The Muni Market and COVID-19: What Bond Investors Need to Know - Adviser Investments

The Muni Market and COVID-19: What Bond Investors Need to Know

October 1, 2020

Episode Description
FEATURING Jeff DeMaso, Chris Keith and Jennifer Zebniak

We’ve all witnessed the severe economic blows dealt to countless companies and private businesses as a result of coronavirus and the resulting shutdowns to stop the spread. Less ubiquitous in news cycles but equally important are the budget pressures state and local governments are facing from COVID-19-related cutbacks and the impact they have on municipal bonds.

Join Director of Research Jeff DeMaso, Senior Vice President, Fixed Income Chris Keith and Research Analyst Jennifer Zebniak as they explain the critical role municipal bonds play in many income-oriented portfolios and how they’re investing in these essential tax-exempt securities under challenging circumstances.

In this engaging conversation, Jeff, Chris and Jen discuss:

  • Potential opportunities and what munis to steer clear of
  • The effect of federal government relief on the municipal bond market
  • How local governments weathered previous recessions
  • … and much more

Municipal bonds—central to the services and infrastructure that keep our cities and towns running—are an essential asset class that relies on stable and consistent taxpayer revenue. For more on how investors should approach munis in the time of COVID-19 and the fledgling economic recovery, click above to listen now!

Episode Transcript

Jeff DeMaso:
Unfortunately, municipal bonds are back in the news and we’re seeing alarming headlines about budget shortfalls. Listen in as we review and dissect the negative headlines and let our cooler heads prevail.

Jeff DeMaso:
Hello, and welcome to another The Adviser You Can Talk To Podcast. I’m Jeff DeMaso, director of research at Adviser Investments. And today I’m joined by my colleagues, Chris Keith and Jen Zebniak. Chris is a senior VP and fixed income manager, though in the office he’s known as “the bond guy.” Jen is a research and fixed income analyst working with Chris to analyze individual bonds. She also does double duty covering actively managed mutual funds with me. Jen and Chris, welcome.

Jennifer Zebniak:
Thanks, Jeff.

Chris Keith:
Thank you, Jeff. It’s great to be here once again discussing our favorite subject, the bond market.

Jeff DeMaso:
That’s right. Today we’re going to talk about the bond market and, in particular, we’re going to talk about the municipal bond market, which despite being nearly $4 trillion in size, in my opinion, doesn’t get the respect it deserves. Municipal bonds are issued by states and local governments to build things like roads, utilities, water systems, new schools, police departments, and much, much more, all of the stuff that make up our cities and towns. And when you buy a muni bond, you’re often helping to fund one of these projects. On top of that, you get a tax break on the interest you earn, too. That’s a double benefit in my book. It’s also why municipal bonds are sometimes called “tax-exempt bonds.”

Jeff DeMaso:
Now, as I said, I don’t think municipal bonds get the respect they deserve. Often the only time we see them in the media and headlines is when something goes wrong or someone is warning about a looming disaster. Unfortunately, today we’re seeing municipal bonds in the news again. We’re seeing alarming headlines about budget shortfalls as like everything, the COVID-19 pandemic is putting pressure on state and local governments.

Jeff DeMaso:
So, let’s just start right there and talk a bit about these budget shortfalls, where they’re coming from, and what you guys are seeing.

Jennifer Zebniak:
Jeff, let me begin by saying that state and local government budgets are both fluid and complex. They depend upon the balance of anticipated revenues and planned expenditures, both of which can change over the course of the year, but budget shortfalls can come from many things. Early this year when the world basically shut down, there was less sales tax to be collected from people eating out or shopping at the mall, less highway and bridge toll money to be collected from people not commuting to work, and lost revenue from income not being withheld from furloughed or laid off workers’ paychecks, for example. Chris, do you have anything to add?

Chris Keith:
Well, Jen, you’re right once again. We always view everything with a cautious eye and I think every investor needs to do that. When it gets to the budget side of things, I really do think that the argument could be made that the state budgets are probably suffering a bigger shortfall than some of the local budgets. The overwhelming majority of income at the local level, and I’m just going to use the city of Newton, Massachusetts, which is the home to Adviser Investments, they have a $440 million fiscal year 2021 budget. The overwhelming majority of that, and I’m talking 75%, 80% of their revenue comes from property taxes. And last time I checked, housing and real estate levels were not negatively impacted here, but are actually rising, so I think that their revenue from ad valorem property taxes is going to be just fine.

Chris Keith:
Now, of course not every municipality in the country is like the city of Newton, but I don’t think that there’s an overwhelming or a big tidal wave of problems coming at the local level. I think it’s more of the states that are reliant upon sales taxes and income taxes than it is the local municipalities that rely more heavily on real estate or property taxes.

Jeff DeMaso:
Okay, so some parts of the revenue side of the equation are under pressure. I guess what areas are being hardest hit and Chris, I guess maybe you don’t think this is the case, but could that be a precursor for the rest of the market? These hard-hit areas?

Chris Keith:
Well, it’s certainly something to be aware of. Problem areas exist. They always have, that’s nothing new. The hardest-hit areas are not representative though of the greater size and scope of the muni market. The overwhelming majority of municipalities, whether you’re a big state or a small town, you’re going to have to tighten your belt but I do think that’s going to be just fine.

Jennifer Zebniak:
Yeah, and just to jump in there, as you can imagine, some of the hardest hit areas are definitely kind of like I mentioned before, anything regarding transportation, sales-tax related, and definitely places that rely heavily on tourism, so think Hawaii or Las Vegas. Personally, I love going to Disney and whenever you purchase something in Orlando, there’s a specific line on your receipt for a tourism tax, so places like that are definitely going to take a hit, but others that don’t rely on that will do much better. I agree with Chris, I wouldn’t necessarily say this as a precursor for the rest of the market.

Chris Keith:
I will add just one last item to that before we move on to the next one, and that is to say that there’s a whole other area of the market, and that would be for example, higher education, small colleges and universities are really going to have to figure out what to do here, because a lot of them haven’t opened their campuses or haven’t opened them fully yet, and they depend upon student activity and student commerce to survive. I think that’s one area that we look at very cautiously. We tend to favor some of the larger state universities or the universities and colleges that have bigger endowments over the ones with smaller endowments.

Jeff DeMaso:
Yeah. There’s clearly a lot of knock-on effects from what we’re seeing from COVID-19. The Disney example, I think, I think is great and they actually just announced a number of layoffs as well. I thought it was 28,000 I saw as the headline and that’s going to reduce income for all those employees and if they’re filing for unemployment, those are benefits that need to be paid out.

Jeff DeMaso:
Maybe let’s talk a bit about how do municipalities, states, and governments manage through this? Within here, Chris and Jen, you’ve both mentioned a little bit on the revenue side, how can they boost revenue and then maybe talk a bit about the other side as well, expenditures, the belt-tightening you mentioned.

Chris Keith:
Sure. I’ll jump in with that one. On the revenue side, they’re going to have to raise revenue, which is another way of saying raise taxes and fees. On the budget side, they’re going to have to reduce spending.

Chris Keith:
Now, look. None of these decisions are going to be easy or popular. Nobody wants to see police officers, firefighters, teachers, public health officials, nobody wants to see anybody get laid off, but unfortunately that’s going to have to happen. Nobody wants to see their taxes go up either, but that’s going to have to happen too. At the end of the day, as I mentioned, they’re not going to be quick or easy or popular decisions, but at the end of the day, I do believe that the cities and the states will make the necessary decisions and they will end up with a balanced budget and a balanced budget is actually good because that means that all your bills get paid for the next fiscal year and included in those bills would be debt service, meaning principal and interest payments to bond investors.

Jennifer Zebniak:
Like Chris just mentioned, none of those decisions to be made are easy, but there are decisions that have to be made during tough times and they’re not necessarily permanent. When things do turn around and start to get better, some of those decisions can and will be reversed.

Jeff DeMaso:
So one area you guys didn’t mention was the federal government and the Federal Reserve. Is there any way that those two levers can be pulled to try and help municipalities?

Jennifer Zebniak:
Definitely and both have already stepped in. Let’s look at the Fed first. They’re stepping in as a buyer of last resort. I say that because these states and municipalities, they’re going through the primary market first. If, say they end up with no other choice because no one wants to buy their bonds, then they can turn to the Fed. This is an option that they currently have. So far only Illinois and New York transportation have taken advantage of this and have actually had their bonds bought by the Fed. Turning to the federal government and Congress, for example, the CARES Act. That included one-time stimulus payments and then temporary supplemental unemployment payments. Those helped hold up consumer spending to a degree that does in turn help sales tax revenues if people are going to then go around and spend that money. The law had also allocated $150 billion for expenses directly attributable to the pandemic. Some of the examples of where this aid went was education, health care and airports.

Chris Keith:
Jen, you bring up a very valid point there talking about the fed. The Fed in their intervention into a taxable corporate bond market has received a lot of attention and they have been very active in there, but they really haven’t been active in the municipal bond market. As you mentioned, we view them as the lender of last resort. Right now, their preference is for municipal issuers to try and tap their traditional municipal bond market and if they’re frozen out or if they have to pay too high of a rate, meaning a punitive rate, then they are the lender of last resort and they do step in. They’ve only been used twice so far. That doesn’t mean that they won’t be used again but right, now they’ve only been used twice and that’s indicative of a market that’s actually functioning and functioning well.

Jennifer Zebniak:
Exactly.

Jeff DeMaso:
Yeah, I think that’s a great point. What I’m hearing a little bit is that we’ve kind of been here before. Clearly the pandemic is new in our lifetimes and it’s been a severe decline, but we’ve been through recessions before where revenues were taking a hit and belts had to be tightened a bit. We’ve come through the other side and we will come through to the side on this pandemic as well. How quickly do you expect a rebound in state revenues once this passes?

Chris Keith:
Well, you’re absolutely right. This is a been there done that situation as far as the recession is concerned. Many of the cities and towns in the states out there have experienced this before. Even though there were difficult decisions to be made then, they did survive and it will happen again. It’s just the way the market works.

Chris Keith:
As far as how long it will last, I think we’re starting to see some signs of recovery already. I point to a couple of things that I made some notes here. In our home state of Massachusetts, sales tax receipts totaled $614 million in July. I don’t have August data yet. That’s actually $11 million more than what they received or what they took in in July of 2019.

Chris Keith:
It’s the same story in other states. Texas, Michigan, Connecticut, Indiana, and many others are seeing an increase or a rebound in sales tax revenue. Now, not everybody is rebounding to the same degree. I know New York and New Jersey are coming in a bit slower. Although New Jersey, actually, I saw the data on them, they came in and virtually broke even with July of 2020 revenue versus July of 2019. Even the state of Illinois, which is probably the poster child for some financial stress and difficulties, their July sales tax revenues were really only off by about 1.5% to 2% versus a year ago, so we are starting to see a rebound in economic activity. We’re starting to see consumers go out and do what they do, consume, and as states reopened or gradually do so, so will their revenues rebound. That’s my expectation. It’s not going to happen overnight, but it’s not like it’s not happening at all.

Jeff DeMaso:
Right, so then the natural question is maybe to try and bring it back to the market in our portfolios, how are the budget stresses and maybe more so the headlines affecting the muni market and how do you think about that as we try and manage client assets?

Jennifer Zebniak:
Budget stresses are always going to have an impact on the muni market because it is an asset class that relies on stable and consistent taxpayer income in sales tax revenue. In the middle of a pandemic, and then the headlines on top of it, is stressful enough. It definitely causes some fear, so of course, it’s going to add stress on budgets for both individuals and governments that have to deal with this, but we haven’t changed our process. We’ve always looked at everything cautiously.

Chris Keith:
I would agree with that. I would just add on that what are we doing different? Well, we’re looking at everything with a very watchful eye. There’s a lot of tools and resources that we use to help us monitor the portfolios that we manage. We’re reviewing everything with a fine-tooth comb.

Chris Keith:
I would say Jeff, that we are improving the credit quality of our holdings. Think of it as addition by subtraction. We’re adding to the credit quality by subtracting the pieces or the bonds at the bottom of the credit quality ladder, if you will, and removing them from the portfolio and adding higher-quality names at the top.

Chris Keith:
Now, just to give you an example of something that we might be doing, large city transit systems, this sort of in the cross hairs here, where people aren’t riding the subway to get to work anymore. That’s one area that revenue has greatly diminished for some of these transit systems. That’s an area that we’ve taken a very close look at.

 

We know that in New York, for example, the transit system depends on a variety of sources of revenue. There are some bonds that are backed by just the transit fees, those are represent the bottom of the safety ladder if you will. Then there are some bonds that are backed by the transit fees and motor vehicle fuel sales taxes. Then there are some bonds that are backed by the transit fees and a dedicated income tax. You can see it a wide disparity on the market level of these bonds. While some might be trading down towards 100 cents on a dollar or slightly above or slightly below, others are trading well above that. Investors know what to look for, at least we know what to look for, and those are the areas that we’re focusing on.

Jennifer Zebniak:
Yeah, and that gives a good example of what we look for in what we do every day. We don’t want to just jump into buying anything or something without knowing exactly what we’re getting ourselves, or our clients for that matter, into.

Jeff DeMaso:
Yeah, I think that’s a great example of just how complicated the municipal market can be at times. Sometimes you think it’s meant to be very straightforward but understanding the different sources of revenue backing the bonds can take a bit of digging.

Jeff DeMaso:
You both have brought a measure of calm to the opposite of the headlines that I’ve been reading. I’m guessing from your comments here that you’re not suggesting that we just follow the headlines and get out of the asset class.

Jennifer Zebniak:
I’d say definitely not.

Chris Keith:
Yeah. As I mentioned a few minutes ago, the cities, the states, and the towns, they’ve survived previous economic downturns and this too shall pass. They will survive this one.

Chris Keith:
As I mentioned before as well, there are always exceptions, but I think that there’s not going to be a tidal wave of bankruptcies or defaults that’s about to swamp the market. As far as investors are concerned, I think they need to be prepared to see negative news headlines and I think that those headlines are actually worse than what the actual outcome will be. Downgrades to credit ratings do not equal missed principal and interest payments. I think that’s a big distinction between what’s going on here. There’s a long way between making budget cuts during a rating downgrade and any impairments for bondholders, which is another way of saying losses of principal or interest.

Chris Keith:
I would leave our listeners with just a couple of takeaways. One, there are budget gaps and there are strained finances. We’re not trying to gloss over that, but that doesn’t mean that bankruptcy is the next stop. There will always be some, but I don’t expect a big wave of bankruptcies to swamp the market and investors should expect to see additional negative headlines, after all, it is an election year.

Jeff DeMaso:
Chris, that’s a great summary. I don’t think I could have said it better myself, so I am not going to try. I’d like to thank both you and Jen for joining me on this episode of The Adviser You Can Talk To Podcast.

Jeff DeMaso:
If you’ve enjoyed this conversation, please subscribe and review our show. You can check us out at adviserinvestments.com/podcasts. Your feedback really is always welcome. If you have any questions or topics you’d like us to explore, please email us at info@adviserinvestments.com. As always, I’d like to thank Kailey Steele and Ashlyn Melvin, our editors, for making this podcast a reality and thank you for listening. Stay safe.

Podcast released on October 1, 2020. This podcast is for informational purposes only. It is not intended as financial, legal, tax or insurance advice even though these topics may be discussed. Information and events addressed in this podcast, as well as the job titles, job functions and employment of the podcast’s participants with respect to Adviser Investments, LLC may have changed since this podcast was released. For more information on each individual featured in this podcast, see the Our People section of our website.

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Cities and states will (typically) balance their budgets…That means all of their bills get paid for the next fiscal year, including principal and interest payments to bond investors.


Chris Keith

Senior Vice President, Fixed Income Manager

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