The COVID-19 pandemic has become the catalyst for what’s becoming known as the great liquidity crisis of 2020. This has directly affected issuance, which has declined precipitously. While a decline in supply will be helpful in stabilizing the market, investors have wondered whether the absence of liquidity for municipalities could metastasize into a more serious credit crisis.
On March 20 the Fed took steps to stabilize taxable money market funds with a program to provide risk-free loans to banks that purchase qualifying assets from money market funds. For the first time, this program will include short-term municipal bonds—as long as they’re rated AA or better with maturities no longer than 12 months. This should make it easier for cities and states to raise funds. In the near term, as long as issuers have the ability to raise cash, a widespread credit crisis won’t occur.
Let’s look at how the liquidity crisis got started, its impact on a few high-profile sectors, and how government actions may help prevent a credit crisis.
We believe the unprecedented backup in yields that began on March 6 has been a liquidity issue. Retail investors, the dominant source of demand in the municipal market, have been net sellers. What may have started as a reallocation from fixed income to equities has evolved into a full-fledged onslaught with the acceleration of mutual fund outflows.
The week ending March 16 was a record for outflows, according to Refinitiv Lipper. At $12.8 billion, it was nearly double the previous record of $6.9 billion, which was set in September 2008. Fund managers were forced to sell, repricing the market in savage fashion. Fund outflows can be a self-reinforcing phenomenon as liquidations force selling that drives down prices and hits net asset values, which in turn causes more nervous investors to liquidate.
Credits under pressure
As mentioned earlier, taxable money market funds are coming to the rescue of short-term municipal bonds in need of assistance. However, not all municipal issuers are equal. Some will face challenges—if they aren’t already—from the mounting effects of the COVID-19 pandemic. Airports, transit systems, and hospitals are among the credits immediately impacted—let’s see how.
Sky travel is in a tailspin of late, with domestic bookings down 70%. Airport revenues often rely on not only enplanements but also parking and concession revenue, which are all suffering. Airport revenue models assume airlines will continue to operate long term. While individual airlines come and go, the core assumption is that air traffic will recover from any short-term disruptions—a theory tested during travel lulls like 9/11 and SARS.
Many large airports like O’Hare International in Chicago, Miami International, and Detroit Metro operate on a residual revenue model that shifts demand risk onto airlines. According to our analysis, airports that rely on this model would experience a negligible impact from a 10% decline in passenger volume. That being said, a 70% decline in bookings over a two-month period works out to be an 11.6% annual decline.
Some large airports like Dallas/Fort Worth International, Los Angeles International, and Denver International operate on a compensatory revenue model that allows them to raise rates when traffic recovers. Airports using this model typically have higher operating margins, and their bonds have higher required debt service coverage.
To date there have been no defaults in the history of general airport revenue bonds.
Many transit systems around the nation have already been impacted by COVID-19. As shelter-in-place rules are adopted by several states and cities, transit systems will likely see further reductions in revenue. Given their essential nature, downgrades are possible, but defaults are unlikely.
New York’s Metropolitan Transit Authority (MTA) is a major system in an area currently under a shelter-in-place rule. The MTA has annual revenue of $15.7 billion, with roughly 50% coming from fares and the remainder from taxes. Since the latest travel restrictions were implemented, ridership has been down roughly 48% for New York City Transit Authority buses and 90% for Metro North. Bridge and tunnel vehicular traffic has decreased by 20% as well.
The MTA estimates that it’s losing $87 million per week, which equates to $3.7 billion annually if current levels of use persist for six months, with a gradual return to pre-virus use thereafter. The MTA has $3.86 billion in liquidity. Additional liquidity could be found by delaying capital expenditures. The MTA has already petitioned the federal government for a $4 billion bailout and was downgraded to an A- credit rating by S&P® on March 24.
MTA bonds are secured on a gross revenue basis, which means a principal and interest default is unlikely, but the credit will become increasingly stressed should the crisis drag on. With New York state law specifically prohibiting the MTA from filing for Chapter 9 bankruptcy, the MTA could find itself docked in the station for longer than expected.
As the numbers of those infected with COVID-19 continue to rise, hospitals are in a particularly tough position. The immediate credit risks for health care issuers come in the reduction of revenues and the increase in costs. Hospitals are being forced to cancel or postpone more profitable elective procedures. The pandemic has created unbudgeted costs due to increased staffing needs and rising premiums for items such pharmaceuticals, medical supplies, and protective gear.
Large, well-capitalized health care systems have the financial cushion to absorb virus impact. However the most vulnerable providers, such as urban and exurban stand-alone community hospitals and academic medical centers, have limited cash reserve cushions. In addition to the high percentage of Medicare and Medicaid payers using these facilities, finding adequate funding to overcome growing deficits could become problematic.
Bonds backed primarily by income and sales taxes will be impacted by a decline in economic activity. Many issues have high coverage ratios. New York State Personal Income Tax bonds, for example, have 6.2 times the coverage. However, the more specialized an issue becomes, the less cushion it’s afforded.
Houston Hotel Occupancy Tax bonds, for example, are secured by a 5.65% lien on a 7% tax collected on all hotel and motel bookings in addition to ancillary parking revenue. Debt service in 2019 was close to $48 million, and revenue was almost $78 million. The bonds have 1.6 times the coverage and a substantial debt service reserve fund of $36 million. Bonds could withstand a 38% annual decline in revenue—the equivalent of no revenue for 4.5 months—and still meet debt service without tapping the reserve fund.
The bottom line
Fiscal remedies are expected, and they’ll be important in mitigating the economic damage caused by measures to suppress the virus. The consensus is that the upcoming stimulus bill will include direct aid to hospitals, airlines, and industries particularly impacted by the pandemic. Additionally, block grants to the states may be used to support transit systems even if there’s no direct bailout.
We believe sectors such as general obligation bonds, water and sewer bonds, and highly rated higher education will experience limited impact from the pandemic. As always, individual issuers in any sector may be challenged. It’s important to do proper credit research or to work with a manager that does. This may help prevent further losses while the economy continues to face a significant economic downturn.
Potential Parametric solution
Constructing your own bond ladders—and factoring in interest rate risk, credit risk, and other crucial aspects of fixed income investing—can consume an advisor’s time. Parametric’s professionally managed municipal and corporate ladders make it easy, helping you oﬀer your clients portfolios tailored to their needs, all in a way that’s simple and scalable for you.
Evan Rourke, CFA, Director, Fixed Income Portfolio Management
Evan is a municipal portfolio manager on Parametric’s Fixed Income Investment Team. He is responsible for buy and sell decisions, portfolio construction, and risk management for the firm’s tax-advantaged bond strategies. He joined the firm in 2009 (originally as an employee of Parametric’s parent company, Eaton Vance). Evan began his career in the investment management industry in 1987. Before joining Eaton Vance, he was a vice president in the tax-exempt fixed-income group of M.D. Sass Investors Services and senior vice president in charge of Banco Popular’s municipal arbitrage account. He was previously affiliated with Prudential Securities, Kidder, Peabody & Co., Paine Webber, and Municipal Arbitrage Applications. Evan earned a BA from Stony Brook University and an online MBA from the University of Phoenix. He is a CFA charterholder.
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