Despite the possibility of a recession, Thornburg Portfolio Manager Eve Lando believes municipal bonds are well prepared to weather the downturn.
The topics of inflation and recession dominate nearly every investor conversation these days, as many are rightly concerned about seeking shelter and protecting their portfolios if a recession begins. We believe that municipal bonds, with their exceptionally strong fundamentals, are better positioned to weather the potential storm ahead. In this article, we take a closer look at why munis may be an unexpected haven during volatile times.
A healthy fiscal starting point
Since the onset of the COVID-19 pandemic, many state and local governments have received substantial fiscal support, and a number of these have deployed their stimulus money to establish rainy-day funds in order to better fortify themselves against future downturns. Tax revenues have also been surging from sales, personal and property taxes. In 2022, nearly every state collected around 10% more in sales tax than it did in 2021, and general fund revenues exceeded projections by 20%. Many municipalities began 2023 with manageable levels of debt and ample cash reserves, and they are in exceptionally strong fiscal positions.
Stability of municipal bond ratings in past recessions
Source: Moody’s
Stability in periods of crisis
All things considered, munis are in much better shape today than they were at the beginning of the Great Recession of 2008, when many states and governments faced sudden and severe budget shortfalls. Any recession this year or next is not expected to hit the financial markets the same way. In fact, compared to other bond markets, the credit-quality ratings of the municipal sector have been very stable, not only during the COVID-19 crisis but also during the Great Recession of 2008 and other previous economic downturns. Municipal default rates have also remained low through many crisis periods, including in 2008.
The chart above highlights the municipal credit “rating drift” as compared with that of corporate bonds. In both 2020 and 2008, municipal credit rating changes were minimal with a rating drift of nearly zero, while corporate drifts were significantly more volatile. Currently, no states are on negative outlook and several are even on positive outlook. Moreover, on average, states and local governments have only spent about half of their federal COVID aid.
The stability of municipal credit quality during times of crisis may be surprising but can be better understood through highlighting the essentiality of this sector of the fixed income market – society cannot do without essential services provided by municipal issuers. The recent real estate slump serves as an excellent example of how municipal bonds can be better adept at riding out local market volatility.
Most agree that the cooling housing market could impact state and local government revenues where there is heavy reliance on property tax collections. Note that the impact of declining home values is usually not immediately felt, as there tends to be a lag between housing-market trends and the point at which property values are reassessed and taxes are recalculated to reflect those changes. Many governments, in fact, will have a couple of years before current housing price movements actually start to affect property taxes in any significant way. This additional lead time allows property tax revenue to temper the volatility of the real estate market, providing a revenue stream that is more stable and resilient to a downturn.
Many levers to pull to meet shortfalls
Not only do states and municipalities enjoy a diverse array of income streams, but when a revenue shortfall does occur, there are many different levers they can pull in order to meet their debt obligations. At a high level, states can tap into their cash reserves, raise more revenues by increasing or adding taxes and usage fees, or control expenses by cutting programs. Below, we examine how state and local governments may overcome inflation and recession-related hurdles through both income generation and expense-control capabilities.
Revenue-Enhancing Levers
Inflation affects tax collections, but exactly how much so will vary depending on the type of revenue stream. Certain types of tax collections offer a stronger inflation and recession buffer than others do. For example, sales-tax revenue provides a better inflation hedge: These taxes are generally calculated based off of nominal prices, allowing the revenue to closely track the ups and downs of inflation. Personal income taxes also tend to hold up well during inflationary periods due to wage inflation, and collections on essential services with inelastic demand — such as utilities, water and sewage treatment — will also continue to offer stable revenue streams during an economic downturn.
Expense-Reducing Levers
Few local governments can absorb the impact of an economic downturn solely by increasing revenues alone. Fortunately, states and municipalities have tremendous decision-making power and flexibility to augment or scale back on program offerings depending on the severity of the revenue shortfall. For instance, educational spending is among the largest expense categories for most states and municipalities. While many of these programs and services are considered essential, or even mandated, a number of expenses are discretionary and may be modified or reduced
For example, within educational funding, during a budget shortfall a city might opt to scrap non-core services by reducing school transportation services or reducing the number of bus routes offered. Decreasing park and recreation spending or suspending related infrastructure spend are a couple of other options that may be considered. In other words, capital projects may be postponed as needed to weather the recession.
Munis as a portfolio ballast
In sum, while the overall macroeconomic environment is on shaky ground, we are optimistic that municipal bonds are better positioned to overcome the twin challenges of inflation and recession risks. Furthermore, the lead time between the start of a recession and any slowing in a municipality’s revenues gives issuers ample time to prepare and adjust, helping to protect their credit ratings and reducing the likelihood of defaults as compared with that seen in other bond sectors. We believe an investment team that utilizes a bottom-up research process to uncover high-quality municipal credits is better equipped to understand the nuances and idiosyncrasies of muni bond investing and to navigate the volatile times ahead.
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