Municipal Bonds & COVID-19: What is going on?
Prior to the outbreak of COVID-19 in the US, the municipal (“muni”) bond market was strong. Investors looking for a non-taxable rate of return were hungry for municipal bonds, driving interest rates down for borrowers (state and local governments) and pushing more debt into the marketplace. Most governments have a cap on the amount of non-taxable municipal bonds they can issue, so many had expanded to include taxable bonds (at a higher rate of return for investors and a higher interest rate for borrowing).
Historically, muni bonds have been very low risk. The rate of default on municipal bonds is very low, and investors see muni bonds as a safe haven for return. The rate of return is often quite low, as determined by the safety of investment, but from a portfolio standpoint, they are a safe addition. As of the end of 2019, the muni bond market was incredibly strong; perhaps the strongest it has ever been. Many state and local governments had strong “rainy day funds” or days of cash on hand, making the risk of default even lower and the bond rating even higher.
Then, COVID-19 made its way to the US and changed the marketplace. Muni bonds have historically performed well during economic downturns, as issuers rarely default– specifically those with great bond ratings. COVID-19 changed this perspective within the market. Investors began selling off everything, including municipal bonds, leaving issued debt sitting in the market unclaimed and driving up interest rates for borrowers. The stock market followed suit, dropping rapidly over just a matter of days, pushing many to wonder if the US was headed for another recession. Why did this happen? And most importantly, what is next?
Let’s start with “why?”
COVID-19 has changed the role and outlook of state and local governments. While otherwise performing strongly and having relatively robust rainy day funds, the revenue timeline changed. The federal government announced an extension of “tax day” from April 15th to July 15th, meaning that these budget-neutral government entities have to wait another 3 months to get the majority of their operating revenues. For utilities, specifically those in North Carolina, the essential nature of water and wastewater service during a pandemic drove many utilities to preemptively promise not to cut off any service for non-payment. As of March 31st, the governor of North Carolina signed an executive order, prohibiting utilities terminating service for non-payment for 60 days, and encouraged utilities to return service to those homes that had previously been cut off.
This is met with a nationwide economic downturn. As Americans are urged to stay home and non-essential businesses are ordered to close, employees in the service industry, among others, are losing their jobs. Approximately 22 million Americans have filed for unemployment since a National Emergency was declared, highlighting that a large portion of the American workforce may not be able to make ends meet. Additionally, this means more people looking for social safety net benefits, and more of a burden falling on these local government units.
In short, local and state governments are going to experience a revenue shortfall combined with an increase in their costs. From the utility perspective, commercial water use will most certainly decline, and residential water use will grow. The amount of revenue shifted is unknown as of now, but will impact the bottom line and the ability to collect in the short term. Additionally, no late fees or penalties can be collected over the 60 day period in North Carolina, beginning March 31, 2020, under Executive Order 124, and in many cases the missed payments can be extended over time for customers that are unable to pay, meaning that it could be 6 months after the pandemic subsides before utilities have regained the lost revenue. There will likely be some account receivables that remain on the books even longer.
Okay, back to the muni bond market. All of this plays into the debt service coverage ratio. Utilities are expected to have a certain amount of revenue above expenses as part of most bond covenants. According to Moody’s, the value of covenants is “high” for revenue bonds; the common bonding mechanism used for water and wastewater projects. The Debt Service Coverage Ratio provides stability and reassurance to investors that they will be repaid. But, what happens when those operating revenues are slashed? When the costs of doing business stay the same, or even increase due to additional reporting and FMLA leave? Then what? The concern is that everything will change; muni bonds might begin to default.
This uncertainty left a lot of investors scrambling to pull money from muni bonds, choosing liquidity over a historically low-risk investment. After a few days of serious concern in the muni bond market, things seem to have calmed down, but the future is still uncertain.
What is next?
Utility revenue shortfalls seem to be a real issue in the next couple of months. Commercial use will decline and some residential customers will not be able to pay their bills. This puts a little bit of concern in the minds of investors, but the good news is that the Fed is supporting the muni bond market. This helps to restabilize the market and set investors minds at ease that the “ole reliable” muni bond will continue to keep its namesake. While it is unlikely that local and state governments will be anxiously issuing new debt, specifically for capital, as of now there is some comfort that muni bonds will remain a reliable investment.
A recent article from Bloomberg seems to suggest that “riskier” muni bonds, like those for senior care facilities, specific recycling purposes, and transportation may be at risk of default, but there is little mention of water and wastewater debt. Unfortunately, it seems inevitable that the historically low default rate by local and state governments will rise. The question is, how much?
For now, we have to wait and see. As we better untangle the uncertainty around the pandemic, we can better assess the short and long term impacts to utility revenues and financial markets. More information to come!