Municipal market update and sector thoughts

The world was a different place only a few weeks ago. Municipal
bond funds had experienced 60 straight weeks of inflows – a record streak
totaling around $75 billion.1 But fast forward to the week ending
March 18, 2020, and fears of COVID-19 caused municipal funds to experience $12
billion in outflows, another record.2 Outflows began mostly in high
yield funds, forcing fund managers to sell bonds to meet redemptions. Because
most high yield municipal funds hold 30%-60% of their positions in investment
grade bonds, selling pressure rippled through the entire municipal market,
leading to further outflows across municipal funds. As markets tumbled,
investors shifted from a “flight to quality” stance to “flight to cash,” putting
pressure on short-term municipal securities and resulting in larger than
expected price declines in short and ultra-short municipal funds.

Liquidity, liquidity,

Market participants in all markets, not just municipals,
have been seeking liquidity. Sellers have been willing to accept large discounts,
further driving down prices. However, on March 20, the Federal Reserve (Fed) stepped
in to provide liquidity to the municipal market. The Fed announced it will allow
short-term municipal bonds to be used as collateral in its emergency lending
program. The Fed further expanded its support to municipals by including
variable-rate demand notes (VRDNs), which are widely held by money market funds.
Making short-term municipal bonds eligible as collateral in emergency Fed
lending has increased the demand for these securities, improved liquidity and
allowed the municipal market to find more stable footing as of March 24. 

Below we highlight the impact of the coronavirus pandemic on
some key municipal sectors that we follow:

Higher education

Prior to the coronavirus outbreak,
Moody’s upgraded its 2020 outlook for the higher education sector to stable
from negative, citing steady revenue growth and solid reserves. Because of
the coronavirus, higher education institutions have announced their
transition to online learning, closed dorms and sent students home. We
believe higher education institutions generally have resources to help cushion
the impact of temporary reductions in revenue and increases in expenses related
to the coronavirus. These resources may include cash, investments,
endowments, government funding and ongoing contributions from alumni and other
donors. But the overall impact on the sector depends on the severity and
duration of the virus. The impact on individual institutions will likely vary
according to their overall financial strength prior to the virus
outbreak. Smaller, poorly capitalized institutions that rely heavily on
tuition revenue, and those already challenged by declining enrollment and
financial resources, will likely be more significantly affected if the impact
of the virus is prolonged. 

Public power, water
and sewer

These utilities are viewed as essential services, vital to
America. We expect these services to continue to be provided and used. In the
unlikely event of large revenue declines in these sectors, it is our belief
that state and federal governments would step in to provide the necessary support.


Hospitals may face higher expenditures (staffing, overtime,
supplies) if inpatient volumes increase and patient stays become lengthy due to
COVID-19. The proportion of low-margin business (urgent care and outpatient
visits) may rise, as patients seek to determine their illness, and higher-margin
business declines as elective surgeries are delayed. Fortunately, a large majority
of hospitals have planned for seasonal flu and other outbreaks, and many have
liquidity and plans in place to handle a crisis. Because the population most at
risk are the elderly, who are covered by Medicare, we do not foresee a huge
surge in uninsured patients due to the pandemic.


Although airports are experiencing decreased activity, they
generally maintain strong liquidity and debt service coverage, and we do not
expect defaults in this sector. According to Moody’s, the median days of cash
on hand for the sector was 659 in fiscal year 2018, the highest since Moody’s
began tracking this metric in 1999.3 It is worth noting that
airports have weathered difficult market conditions before, including the sharp
drop-off in travel post 9/11, without default.

Additionally, many of the large airports have either “residual”
or “hybrid” use and lease agreements with signatory airlines, in which airlines
are obligated to cover the net costs and debt service of the entire airport in
the event that revenue from airport operations is insufficient. Failure to do
so could result in the termination of airlines’ landing slots and/or terminal
gates. Some airports have a “compensatory” rate-making framework, in which
airlines are only charged for the costs of the facilities they use. These
airports could be at risk of a credit downgrade if there is a prolonged
downturn in airline activity. However, airports operating under this framework tend
to have slightly higher levels of liquidity and debt service coverage. Notably,
the credit profile of an airport is largely insulated from the financial
profile of its parent government because of Federal Aviation Administration
limitations on the distribution of excess revenues to the parent government.

Toll roads

Like the airport sector, toll roads will likely see a
decrease in activity but, because of strong liquidity and debt service
coverage, we do not expect a material increase in downgrades or defaults. The
use of toll roads was healthy prior to the coronavirus outbreak, and we expect it
to recover when the crisis abates. Toll roads are also supported by fully
funded debt service reserve funds that are typically sized at the lesser of a)
the maximum annual debt service, b) 10% of outstanding debt and c) 1.25 times
average annual debt service, further providing a financial cushion.4

State general
obligation bonds

Invesco Fixed Income expects the credit quality of most states
to remain stable because of historically high rainy-day funds and the ability
to manage revenues and withhold payments to local governments, such as cities
and school districts. In fiscal 2019, the median rainy day fund equaled 7.5% of
general fund spending, which is an all-time high and compares to roughly 5%
before the 2009 recession.5 States most likely to be hurt by the
economic fallout of the coronavirus are those heavily reliant on tourism and
the oil and gas sectors. Also, states with high underfunded pension liabilities
may need to increase pension contributions because of low market returns, but we
believe these states will face increased credit downgrade risk and not increased
default risk.

Continuing care retirement
communities (CCRC)

CCRCs are at risk, but we believe a repeat of the tragic situation
in Washington State becomes less likely as more is understood about controlling
the spread of the virus. CCRCs serve the population most vulnerable to the
virus but they offer all levels of care with health staff onsite that can
detect and treat residents as soon as the virus is detected. Seniors living in
a CCRC would likely receive treatment sooner than seniors living at home. However,
any CCRC, even one with no contagion, faces the idiosyncratic risk that it
could be perceived as a health risk, and that could impact its ability to
attract future residents.

Looking ahead

We cannot predict when the coronavirus pandemic will abate
or how acute market volatility will be going forward. But we believe there
will be a bottom at some point. Municipal credits have a long history of low
default rates, and while we might receive a temporary tax break or a government
check, none of these will permanently lower our taxes. Municipal bonds are one
of the few sources of income that is not subject to federal taxes — and that
income is now more attractive than it was at the beginning of the month.

Professional management
is fundamental

Invesco Fixed Income’s team of dedicated municipal credit
analysts is among the most seasoned in the industry with over 21 years of
research experience.6 Our team continuously analyzes the municipal universe
to identify investment opportunities or deterioration in credit quality. Site
visits are an important part of our bottom-up fundamental research process.
Credit analysts perform 150-200 site visits and management conference calls per
year. This specialization means that every bond is thoroughly vetted before
being selected for portfolios.

1 Source: Lipper, data as of February 26, 2020

2 Source: Lipper, data as of March 18, 2020

3 Source: Moody’s, “Fiscal 2018 Medians Economic
growth, lower fares continue to under financial performance (Airports – US)
November 20, 2019

4 Source: Invesco

5 Source: Moody’s, “2020 outlook stable with
continued revenue growth and record reserve levels (State government – US)
December 3, 2019

6 Source: Invesco, data as of December 31, 2019

Important information:

A bond issuer may cease to be rated or its
ratings may be downgraded. Such action may adversely affect the value of the

Municipal securities are subject to the risk
that legislative or economic conditions could affect an issuer’s ability to
make payments of principal and/or interest.

The value of the bonds will generally fall if
interest rates, in general, rise. In a low interest rate environment risks
associated with rising rates are heightened. The negative impact on fixed
income securities from any interest rate increases could be swift and
significant. No one can predict whether interest rates will rise or fall in the

Invesco and its representatives do not provide
tax advice. Individuals should consult their personal tax advisors before
making any tax-related investment decisions.

The opinions referenced above are
those of the authors as of March 25, 2020. These comments should
not be construed as recommendations, but as an illustration of broader themes.
Forward-looking statements are not guarantees of future results. They involve
risks, uncertainties and assumptions; there can be no assurance that actual
results will not differ materially from expectations.

This does not constitute a recommendation of any investment
strategy or product for a particular investor. Investors should consult a
financial advisor/financial consultant before making any investment decisions.
Invesco does not provide tax advice. The tax information contained herein is
general and is not exhaustive by nature. Federal and state tax laws are complex
and constantly changing. Investors should always consult their own legal or tax
professional for information concerning their individual situation. The
opinions expressed are those of the authors, are based on current market
conditions and are subject to change without notice. These opinions may differ
from those of other Invesco investment professionals.

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