As the COVID-19 pandemic continues to spread, economies across the country are experiencing unprecedented disruption. Most revenue streams that secure municipal bonds, either directly or indirectly, are already coming in lower than originally projected. Some are a fraction of what was expected, while others have only dropped modestly. We expect that revenue bonds, which account for approximately two-thirds of all municipal bonds, should be more stable than state and local general obligation bonds.
Diverse tax revenue streams typically support the full-faith-and-credit pledge to holders of state general obligation bonds. While state revenue sources differ, most involve some mix of personal income tax, corporate income tax, and sales tax.
When the economy contracts, sales and income taxes have historically been the most vulnerable, often falling quickly. Along with lower revenues, an increase in spending on various measures to combat the impact of the COVID-19 virus has resulted in slashed fund balances. Increased pension liabilities, caused by deferred contribution payments and returns falling short of expectations, are exacerbating the problem for states and local municipalities. Moreover, states may have to increase short-term borrowing to fill budget gaps. Not all states entered this year with the same financial strength, and the more fiscally prepared should be able to weather this environment. Still, we expect that overall state credit quality should deteriorate from previous years.
Local governments partially sheltered by real estate
Local governments face similar credit challenges as their state counterparts, although they might be less exposed to the impact of the COVID-19 crisis. Most local governments rely on property tax revenues to make up at least 50% of their general fund budgets every year. Property tax revenues have traditionally been a more stable revenue source than sales and income taxes, even during recessions. Moreover, the housing market has been surprisingly resilient during the COVID-19 crisis. The heavier reliance on property taxes should benefit performance for many local municipalities, particularly relative to states, despite the sometimes inferior local issuer quality.
Relative stability potential in revenue bonds
While we remain positive on the long-term prospects for most revenue bond sectors, those backed by utilities, such as water, sewer, and electric enterprises, may prove to be the safest and most stable municipal bonds in the short and long term. Most utilities tend to have significant liquidity and the ability to raise rates. They have strong operational and financial performance throughout the business cycle because their services are essential and their structures are monopolistic. Utilities that serve highly residential areas should have more stable performance than those with significant industrial concentration, especially as customers stay home more.
Toll roads are another sector that should experience relatively few long-term credit problems. While toll roads have seen a decline in usage as fewer people are commuting to work, taking road trips, or traveling in general, many toll road systems can withstand this shock. Toll roads’ median cash on hand at the end of 2019 was approximately equal to 914 days’ worth of expenses, with some systems’ liquidity at over 2,000 days.¹ As economies across the country begin to reopen, we expect that toll road traffic will return quickly. In fact, changing tastes may cause traffic to increase as people choose to drive rather than risk exposure on public transit such as buses, trains, and airplanes.
Airlines and airports continue to face headwinds
The economic shutdown has predictably decimated the airline industry. The airport sector certainly faces more headwinds than toll roads, although many airports are prepared to survive this recession. Many received federal funding from the Coronavirus Aid, Relief, and Economic Security Act, also known as the CARES Act, with more federal aid likely in the next stimulus package. Even before federal assistance, the median cash on hand was 659 days,² suggesting that most airports can withstand this shutdown for an extended period. While it will likely be years before airports see the record traffic levels of 2019, larger hubs crucial to the nation’s transportation network should recover in the long run.
Hospitals are essential to the recovery, but face challenging conditions
We expect hospitals to face the greatest uncertainty. Responding to the COVID-19 pandemic has meant eliminating or postponing most elective procedures, typically their most lucrative revenue generators, with overall hospital patient volume declining beginning in mid-March by 30% to 50%.³ Although revenues started to improve once elective procedures resumed, the current surge of new COVID-19 cases across the country will likely delay a quick recovery to pre-COVID-19 levels. Hospitals have reduced capital spending and salaries and started layoffs and furloughs, but replacing lost volumes and revenues remains the key issue. Federal aid and grants will be crucial for some hospitals.
General obligations bonds are less attractive than revenue bonds
Overall, we believe revenue bonds should see less credit deterioration than general obligation bonds over the coming months. Revenue streams from essential services will face smaller declines than more economically sensitive flows such as sales or income taxes, and many revenue credits may not face tough pension decisions. While robust fundamental analysis will be critical, revenue bonds offer the most stability and best potential for investors seeking to navigate the COVID-19 crisis.
1 Moody's, September 2019. 2 Moody's, November 2019. 3 “A Bumpy Recovery Is Ahead for Hospitals and Other Health Providers as Non-Emergent Procedures Restart,” S&P Global Ratings, May 2020.