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AAM Viewpoints – Emergency Response Management: How Municipalities Are Responding to COVID-19


Six grueling months into this battle against COVID-19, states and municipalities across the country know that even if they manage to successfully suppress the spread of the virus by year end, the fight will still be far from over. According to the National Conference of State Legislators, of the 36 states that have reported revenue declines for fiscal 2021 due to the pandemic (as of August 14), 24 of them will be grappling with double-digit losses that could be felt in the years to come. With no guarantees of any additional federal relief in follow-up to the $2.2 trillion CARES Act, states realize that they will need to take matters into their own hands. Fortunately, municipalities – unlike corporations – have a few options in their toolbox to help address these issues. That said, state leaders will need to weigh the pros and cons of each decision they make because every option comes at a price.

Taxation: Some states are looking to recover lost revenues via taxation. California Democrats recently proposed AB 1253, which is essentially a millionaire’s tax to help pay for K-12 education and government services. Already imposing the highest income taxes in the country, this bill would retroactively raise the rate on top earners in the state to an unparalleled 16.8%. Opponents of this bill will be sure to bring up the drawbacks of these tax hikes at the next legislative hearing, which include the potential to slow future economic growth as well as give more wealthy Californians greater incentive to move themselves, and their tax dollars, out of the state. If passed, tax-exempt California municipals would be primed for a major rally based on the higher tax revenues and higher demand for tax-exempt income.

Budgeting: Other municipalities have already chosen the route of austerity and made major spending reductions for the upcoming year. After vetoing more than a $1 billion in spending from Florida’s fiscal 2021 budget, Governor Ron DeSantis recently compared his budget cuts to the infamous “Red Wedding” episode from the “Game of Thrones” former TV series due to all the “slashings” he made. While these drastic actions are sure to inflict pain on the usual benefactors of those social welfare programs and services (especially for those simultaneously battling the virus and unemployment), budget cuts of any nature would benefit the creditors and bondholders of the state. No decision is going to satisfy all when a tourism-based state is projected to lose billions in revenues between this year and the next. For what it’s worth, the state of Florida has been rated AAA by S&P since 2005 in part due to its long track record of strong fiscal responsibility.

Financing: Just as state and local governments sold over $130 billion of short-term notes between 2009 and 2010, in the wake of the last recession, according to Bloomberg, the urgent need to replenish falling cash flows is setting the stage for municipalities to go on a borrowing rampage in the coming months.

Sales of Short-Term Municipal Notes

Sales of Short-Term Municipal Notes

Earlier this month, the New Jersey Supreme Court gave Governor Phil Murphy the authority to increase the state’s bonded debt by 22%, or $9.9 billion, in order to address the projected revenue losses caused by the pandemic. Under normal circumstances, New Jersey’s constitution requires a public vote to enact such a change to their balance sheet. However, all seven judges of the court unanimously agreed to bypass the procedure. This new ruling would give New Jersey, already one of the lowest rated states in the country, with one of the worst funded pension systems, a much-needed “emergency” capital to keep their systems running into the next fiscal year. That said, the state is likely to receive criticism for their controversial deficit borrowing given how the additional debt burden weighs down on the state’s long-term outlook.

In fairness, Governor Murphy believed he had no other choice as he floated several tax hikes in the past to no avail, including a proposed millionaires’ tax back in February that was intended to replenish their pension system. Though New Jersey’s debt typically trades at a considerable penalty compared to benchmark debt, the state could not have selected a better time to borrow than today, with interest rates at historic lows. The potential to save millions in interest costs might be the only silver lining for municipal issuers during these trying times. Whether they are in dire need of closing funding gaps or simply looking to maximize value out of every tax dollar by refinancing existing debt, we believe municipalities across the country could use these near optimal market conditions of record low rates and voracious investor demand to their advantage.

With a myriad of other options (ie. drawing down rainy day funds, selling assets, forgoing pension contributions, etc.), state and local governments will likely need to access a combination of these tactics, if not all of them, in order to make it through this pandemic intact financially. While there have been headlines surfacing that suggest states should declare bankruptcy to ease their financial woes, every governor in every state knows that the act of restructuring old debts would do absolutely nothing for them today to recoup the millions in tax revenues that they are losing on a daily basis. The arrival of additional stimulus has the potential to help states digest some of these fiscal responses a little bit easier, but for the time being, municipalities must be prepared to act unassisted. As highlighted in the examples above, someone’s gain will inevitably lead to another’s loss with every decision, so state officials really have their work cut out for them.

What Now for Municipal Bond Holders?

According to Municipal Market Analytics, approximately $5 billion of municipal bonds (primarily high yield) have defaulted so far this year and another $40 billion of debt has been downgraded by Moody’s between April and June. These developments drastically heighten the need to continuously monitor portfolio credit quality. Credit uncertainty only escalates for bondholders when even state legislators are having difficulty projecting tax revenue shortfalls. What further complicates matters is historically low rates might be a saving grace for municipal issuers right now, but they are certainly not doing any favors for investors, especially if inflation concerns intensify.  

10-Year Tax-Exempt AAA Real Rates (%)

10-Year Tax-Exempt AAA Real Rates (%)

That being said, despite the lower yields, we believe tax-exempt municipals still offer respectable value on both a relative and after-tax basis. Additionally, the broad municipal asset class will likely maintain one of the highest credit qualities available in the U.S. fixed income markets. The inefficient and bifurcated market has the potential to continue to provide ample opportunities for savvy and knowledgeable investors to exploit and acquire credits at discounted levels. Like states actively fighting hard through this pandemic, gone are the days of “set-it-and-forget-it” municipal portfolios; in are the actively managed and tactical approaches that routinely navigate through ever-evolving credit and rate landscapes, in our view.

CRN: 2020-0806-8492 R

For informational purposes only and not a recommendation to purchase or sell any security. Investors should consult their financial professional. 

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 for the trust units 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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