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AAM Viewpoints – With a Little Help from My Friends (Municipal Cover)


Looking back, it is entirely possible that the historic moves that we saw across financial markets throughout the COVID-19 sell-off could have shaken even the staunchest “laissez faire” capitalist out there. There was no question that such an unprecedented and unforeseen event needed to be addressed and countered with its own unprecedented fiscal stimulus. Once word that a massive Congressional stimulus package was soon on its way, risk asset classes across the spectrum began to reverse course, municipal bonds included. In fact, by the time President Trump signed the $2.2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act into law on March 27, the broad municipal market had already rallied and recovered a large majority of the pandemic-related selloff.

Here is a summary of U.S. Public Finance Provisions in the CARES Act:

Amount  

 Program

 Purpose

$454B

 Treasury Exchange Stabilization Fund

 Provides liquidity and loans to businesses, states, and municipalities

$150B

 Coronavirus Relief Fund

 COVID-19 relief for states and local governments, tribes, and territories

$100B

 Public Health Emergency & Social Services

 Reimbursements for eligible healthcare providers

$25B

 Transit Agency Grants

 Payments to transit agencies to cover operating expenses, lost revenues

$14B

 Higher Ed Emergency Relief Fund

 Funding for institutions of higher learning

$13B

 Elementary & Secondary School Relief Fund

 Relief grants for elementary and secondary schools

$10B

 Airport Improvement Program Funding

 Payments to airports to cover operating expenses

Source: Federal Government; Federal Reserve; S&P

 


Fiscal intervention went a long way to help stabilize market liquidity and all but eliminate the grimmest of credit scenarios that were priced in during the height of the sell-off. For example, the transportation sector has been one of the hardest hit sectors of the municipal market YTD due to the country-wide shutdown. Yet, credit spreads have come a long way since the peak of the dislocation. It could be argued that the balance sheets of many airports, toll road, and mass transit systems improved versus their pre-virus figures. From a liquidity standpoint, key metrics such as Debt Service Coverage Ratios and Days Cash on Hand increased substantially from the direct injection of cash the stimulus provided.

At the state and local level, the Coronavirus Relief Fund has so far been the single most impactful appropriation for municipalities tackling the health and economic expenses of the pandemic. Without it, the billions in cash reserves that states diligently built up over the last several years could have been completely wiped out in a matter of months, if not weeks. According to the Tax Foundation, the $150 billion CRF provision was allocated as follows: $110 billion to states, $29 billion to eligible local governments, $8 billion to tribal lands, and $3 billion to US territories. Allocations were determined largely by population (CA, TX, and FL received the largest shares) with all states provided a minimum of $1.25 billion. Though many politicians have called for additional stimulus to keep the country from falling into a deep recession, most seasoned municipal constituents would be quick to remind others that states and local governments have options that individual corporations do not have. In addition to imposing taxes and making necessary budget cuts, municipalities have the option of issuing debt at levels which are now arguably close to their pre-coronavirus historic low yields.

municipal AAA yield curve since 3/1/2020Source: Thomson Reuters Municipal Market Data (TM3 MMD)

Although liquidity has generally improved with each passing day, the municipal market remains somewhat bifurcated as investors have continued to distinguish between states and sectors, deliberately penalizing the credits deemed to be most impacted by the downturn. In theory, not all issuers would have the option to access the primary market during this time, particularly the lower-rated governments. In response, the Federal Reserve established the Municipal Liquidity Facility in accordance with the CARES Act to bridge the gap for state and local governments unable to secure financing on their own.

Current Terms of the Municipal Liquidity Facility (MLF)

  • The Fed will have the ability to purchase up to $500 billion of short-term notes (no longer than 36 months) directly from U.S. states. The Department of Treasury will fund this Special Purpose Vehicle.
  • As of the April 27th expansion announcement, eligible participants include states, counties with a population of at least 500,000 and cities with at least 250,000 residents. Also expanded was the termination date: eligible issuers have until December 31, 2020 to borrow from the MLF.
  • Eligible entities must also have an investment grade rating from at least two rating agencies and will need to provide written certification that they attempted to raise money elsewhere first.
  • Borrowers will need to pay a comparable maturity overnight index swap plus a spread based on the entity’s long-term ratings. AAA-rated issuers would be charged a premium of 150 basis points. BBB-rated issuers would pay anywhere from 325 to 380 basis point premium.

Source: Federal Reserve Term Sheet (May 11, 2020)

As of the writing of this article, the Fed has yet to lend a single dollar and quite a handful of governing officials have noted that the pricing terms of the MLF are currently too steep to consider. Because the central bank has never in its history directly intervened in state or local government finances, the Federal Reserve has undoubtedly moved cautiously throughout the process, essentially writing terms from scratch. They have made it clear that the MLF was designed to be used as a last resort and not the first option for municipalities (hence the extensive terms and the above-market premium to borrow). Speaking of last resort, the Baa3/BBB- rated state of Illinois, whose yields have recently spiked dramatically and currently has a $1.2 billion auction deal on day-to-day status, has openly expressed interest in borrowing from the MLF. Perhaps the Fed may soon have its first guinea pig borrower to test out its brand-new lending vehicle.

During the 2008 Financial Crisis, then-Fed Chairman Ben Bernanke explained the reason why the Fed chose not to support municipals was because such decisions were “inherently political and jeopardized the freedom of localities from federal financial oversight.” Despite living in unprecedented times today, it appears the crux of this very argument has once again split lawmakers into two camps. On one side, there are officials pleading for the Fed to take more action by supporting longer-dated issuance or even purchasing securities directly on the secondary markets (something they are currently executing for the corporate bond market). House Speaker Nancy Pelosi’s $3 trillion HEROES Act, that would send another round of unprecedented stimulus to state and local governments, recently passed the House. However, the Senate, which currently has this bill stalled, has been growing increasingly wary of the federal deficit. It was not too long ago that Senate Leader Mitch McConnell openly contemplated allowing states to declare bankruptcy versus providing additional stimulus that would only bail out poorly run municipalities with inflated budgets and pension systems. Benchmark municipal yields nearing their all-time lows again and primary markets slowly taking off seem to support the argument for less aid. However, Federal Reserve officials, including Chairman Jerome Powell, have suggested that municipalities may need additional help and advocated for more fiscal relief in recent days. Given that the 2020 election is only months away, we think both parties will eventually come to an agreement in short order. Regardless of the outcome, while another stimulus package would certainly be welcomed by states and municipalities tackling a shuttered economy and record unemployment, it is our belief that the vast majority of municipal issuers have the necessary tools and liquidity to make it out of a prolonged slowdown independently.

 

CRN: 2020-0511-8293 R

An investment in Municipal Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the municipal bond market, possible downgrades, changes to the tax status of the bonds and defaults of interest and/or principal. A bond’s call price could be less than the price the trust paid for the bond. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bond insurance covers interest and principal payments when due and does not insure or guarantee the value of any bond in any way.


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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