Is the Pandemic Putting Municipal Bonds in Jeopardy?
September 11, 2020
By Michelle Holmes, CFA®
AVP - Investments
The global health pandemic has affected our national government, but its impact on state and local governments is also unprecedented. This means that in the coming months, municipal bonds could experience their own unique brand of stress.
What is a municipal bond?
A municipal bond is a type of security issued by a state, county or city government to finance its capital expenditures — like road construction or school buildings. Think of them as a loan that you make to a local government. Municipal bonds are attractive investments to some, because their risk is low and their interest is generally tax-exempt.
Municipal bonds historically have had very low default rates. For example, the overall municipal bond market 10-year cumulative default rate was lower than AAA-rated corporate bonds over the last several decades.
The majority of municipal bond issuers carry an “investment grade rating,” which as shown above, historically means they are less likely to default. Even when a municipality does default, it is likely to keep paying for essential services such as education, public safety, electricity, water and waste treatment; while restructuring or reducing debt in other places.
How has COVID-19 affected municipal bonds?
The global health pandemic is taking a toll on municipal bond issuers, as state and local governments find they are not immune to the economic downturn. In fact, states could face record budget shortfalls over the next year.
The good news for municipal bond holders is that states were generally in better financial health before the start of the current crisis than they were in the past. State reserve funds as a percent of the general fund balance are estimated to be double what they were 20 years ago (as seen in the chart below).
That being said, we have already started to see an increase in ratings downgrades this year, and we will likely continue to see downgrades pick up over the next couple of years, for both municipal and corporate bonds.
Will the federal government help at all?
The first rounds of fiscal stimulus in the CARES Act did provide some relief for state and local governments — about an estimated $150 billion. This is not nearly enough to cover the budget shortfall, however, with estimates closing in on $500 billion through 2022. The House and Senate are divided on another round of fiscal stimulus. The current House proposal includes more funding for state and local governments, while the Senate version offers no additional benefits. The markets believe the House and Senate will reach a compromise and are expecting another round of fiscal stimulus at some point. However, there is no guarantee the stimulus package will include funding for states and local governments.
This highlights the importance of not only understanding what you own, but continuing to monitor your investments after they are purchased — even the bonds you own.
We will continue to monitor the effects and watch to see if the next round of fiscal stimulus provides additional funding for state and local governments. To see how these and other market trends may impact your investments, contact one of our financial professionals today.