Municipal Bond News 5/1/23

State Budget Deal Boosts MTA…Traders Bet on May Hike…High Yield Municipal Bonds’ Yield Advantage…Lower-Rated Muni Bonds Credit Resilient…Detroit Earns Another Rating Upgrade…Municipal Bond Issuers Ready for Recession…California Revenue Underperforms…Experts Debate Public Pension Risks…States and Local Governments Urge Bipartisan Federal Debt Limit Fix…

New York State Budget Deal Boosts MTA…After nearly a month of deadlock, NYS lawmakers reached agreement on a $229 billion state budget. The new plan brings a payroll tax hike to boost MTA funding. The tax hike will bring in about $1.1 billion and NYS will also direct $300 million in one-time state aid for the agency. The funding boost will also reduce a planned 5.5% fare hike for this year and improve transit services. “With this budget, commuters in the New York City region will know that this program will not be jeopardized,” Governor Kathy Hochul said. With ridership at 70% of pre-COVID levels, MTA will also cut back on operating expenses.

Traders Bet on May Rate Hike…A 25 basis point rate hike at the Fed’s May 2-3 meeting has gained higher odds in the bond market. Inflation remains high. Economic growth has slowed. The Fed preferred inflation gauge is down less than a full percentage point from its peak, well above the Fed’s 2% target. However, consumer spending, hiring and home sales have recently slowed. U.S. economic growth fell 1.1% in the first quarter, a significant slowdown from 2.6% in the fourth quarter of 2022. Many economists forecast a recession in the second half of 2023. The Fed is committed to fighting high inflation, even if it comes with economic pain.

High Yield Municipal Bonds’ Yield Advantage…Higher compensation for riskier tax- free bonds has not gone unnoticed by investors. The yield benefit or credit spread on high -yield (‘HY’) municipal bonds relative to top-rated tax-free benchmarks has grown this year. However, when considering HY munis, a professional opinion is a must. Both HY and investment-grade municipal credits carry relatively strong credit conditions as states and locals brace for a mild recession. A municipal bond specialist’s expertise offers valuable insight to investors seeking higher yields. Tax-free bonds issued by lower-rated hospitals, small to mid-sized universities, residential communities, and unrated local governments are often termed HY municipal bonds. Such bonds offer higher yields relative to top-rated municipal bonds. Prominent HY municipal bond issuers include several Tobacco revenue-secured bond agencies, Puerto Rico’s general obligation bonds, and COFINA bonds. Restructured in 2019, Puerto Rico’s COFINA bonds, and Buckeye Tobacco Settlement Financing Authority bonds, which were restructured in 2020, are considered HY municipal bond bellwethers. Long-term Buckeye Tobacco bonds offer yields of around 5.5%, up from 5% a year ago.

Lower-Rated Muni Bonds Credit Resilient… “Even as corporate default rates have more than doubled over the past year, the high-yield municipal sector for now has shown some resilience against higher interest rates, turbulence in the banking sector, and inflation,” Moody’s added that the credit conditions of lower-rated municipal bonds defied the agency’s expectation. Although certain downside scenarios could shake out more of the weakest borrowers in the riskiest corners of the muni market, Moody’s is predicting that municipal delinquencies are unlikely to exceed past pandemic-era levels in case of a mild recession in the second half of the year. Early red flags for potential defaults in the US municipal bond market dropped to the lowest levels since before the pandemic started during the first quarter per Moody’s. Moody’s analysis points to the resilience of even the weakest borrowers in the municipal bond market when faced with less favorable credit conditions.

Detroit Earns Another Rating Upgrade…S&P… upgraded Detroit’s general obligation rating to ‘BB+’ with a positive outlook. The latest upgrade follows a similar rating action by Moody’s last month. Detroit is now one notch away from investment grade rating. “The rating action reflects our view of Detroit’s ongoing efforts toward building financial resiliency, evident in another year of positive financial results and improvements to reserves and liquidity, as well as its commitment to robust financial planning and budgetary management,” S&P stated. Detroit CFO stated, “The back-to-back ratings upgrade from Moody’s and now S&P reflect the overall success of the financial and economic strategies the city has employed.”

Municipal Bond Issuers Ready for Recession…States and local governments much improved fiscal picture with help weather an economic downturn, likely later this year. Many states and local governments are in their best financial shape. Notable credit upgrades, such as Illinois, New Jersey, Connecticut, Chicago, and Detroit, reflect the strength of municipal issuers. Several rounds of federal aid and infrastructure legislation have shored up the financial strength of municipal bond issuers. “There is room for credit improvement in both even if we do hit a recessionary period.” A Nuveen portfolio manager added, “As far as valuations go, there is still plenty of room for credit spread compression and for also picking up additional yield by moving out on the curve.” Municipal bonds tend to rebound in the years following a rout.

California Revenue Underperforms…Lower personal income tax collections have led California’s revenue collections to underperform. Golden State Revenue for the first nine months of fiscal 2023 is about 3.7% lower than Governor Newsom’s January projections. Income tax collections declined, partially offset by outperforming sales tax. A revised budget proposal, with updated revenue forecasts, is likely.

Experts Debate Pension Risks…State and local government pension plans show no sign of a major crisis in the next two decades even if investment returns are low, Brookings Institute finds that fully funding pension plans is an unrealistic goal. Should pensions be considered an eternal liability, pension contributions would not have to increase nearly as much, nor would benefit cuts be too deep. Such a framework could distribute the burden of unfunded pensions over several generations. However, a Moody’s analyst thinks differently, “Deferring contributions to the future reduces governments’ future financial flexibility, making future budgets more dependent on revenue growth to accommodate pension costs.” Since 2009, 40 U.S. states have hiked employee pension contributions. State and local government pension plans hold nearly $5 trillion in assets. Annual public pension payments to 11 million beneficiaries make up 1.5% of national GDP.

States and Local Governments Urge Bipartisan Federal Debt Limit Fix…“States and territories succeed when there is certainty and stability in federal resources,” six leading government organizations including the United States Conference of Mayors, National League of Cities, National Association of Counties, and National Conference of State Legislatures have called for a bipartisan solution to the impending national debt limit. Federal funds made up 38% of state budgets in 2022, up from 31% pre-COVID-19. In protecting state safety net programs such as Medicaid, reimbursed and federal matching programs from brinksmanship at Capitol Hill, National Governor’s Association wrote to Congress “States’ ability to make funding decisions and administer essential programs are inextricably tied to the federal budget.”

Compare 30-Year taxable U.S. Treasury yield 3.69% to 30-Year tax-exempt Municipal Bond yield “AAA” 3.47% “AA” 3.93%; “A” 4.28%. For investors in the    35% tax-bracket, a 4% tax-exempt yield is equivalent to a 6.15% taxable yield. Top- rated long-term tax-free bonds yield 94% of comparable taxable U.S. Treasuries.