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pickup in the expectations component of consumer confidence surveys, suggest that households have the ability and thewillingness to keep consumption growing at a vigorous level.

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CORONAVIRUS AND THE MUNICIPAL BOND MARKETAPRIL 21, 2020

GUY LEBASChief Fixed Income Strategist

The COVID-19 crisis impacted municipal bonds more starkly and surprisingly than many other fixed income sectors.

As we posited in recent Janney Investment Strategy Group reports Municipal Bonds During the COVID-19 Crisis and A Year Within a Day for Fixed Income Markets, the reason that even higher-quality municipal bonds underperformed in much of March is selling and mutual fund withdraws by individuals ahead of uncertain economic times. Municipal bonds are unique in their degree of individual ownership—when many individuals lean on the sell button, muni markets tip over faster than other markets.

The good news, for the moment, is the selling has slowed and Federal Reserve and Congressional support programs appear to have placed a liquidity floor under the markets. That said, the fundamental credit risks that vary starkly from issuer to issuer are just starting to come into focus.

(Source: Janney Investment Strategy Group; Bloomberg/Barclays Indices)

POLICYMAKERS OFFER LIFELINES DURING PANDEMIC

Since March, the Federal Reserve has cut overnight interest rates to zero, supported funding for intermediaries, and launched a series of programs to support the municipal markets.

On April 9, the Fed launched the Municipal Liquidity Facility (MLF) to “offer up to $500 billion in lending to states and municipalities.” While the MLF focuses on lending to states and large cities/counties, the program also allows smaller municipalities to obtain indirect funding via their state. The mechanisms are complicated, but the signal is clear: Monetary authorities are providing enough cash to ensure that government entities will not fail because of a

lack of liquidity. The $500-billion size is large in comparison to the overall $3.9-trillion municipal markets and should be sufficient for short-term needs.

Congress has also provided direct cash stimulus to states. The Coronavirus Aid, Relief, and Economic Security (CARES) Act included a $150-billion “relief fund” which is being disbursed to states presently, and talks of an additional $500 billion in aid are in progress. Unlike the Fed-supplied cash, these funds are grants, not loans, and exist to fill sizable budget holes at the state and, indirectly, the local level.

Muni Markets Were Hit Hard By Individual Investors' Need to Raise Cash Into Economic Uncertainty

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STATES AND LOCAL MUNICIPALITIES CARRY BURDEN

These budget holes form the crux of intermediate- to long-term credit risks in the municipal bond markets.

State governments generate most of their revenues from taxing income, sales, resource extraction, and tourism. The mix varies by state. Economic pain wrought by the COVID-19 crisis will reduce income and has already cut retail sales of everything except for groceries (usually not taxed). Furthermore, plunging oil prices may end up limiting states’ excise tax revenues as well.

Local governments generate most of their revenue from income taxes, state aid, and property taxes—again, the mix varies considerably. Given the reduced incomes, we can expect to see revenue declines at the local level as well. For larger cities that tend to rely more on income taxes, the impact will be swift, although there may be as much as a 12-month lag for smaller municipalities given their reliance on property taxes.

On the other side of the ledger, state expenditures are, in many cases, rising. States generally pay unemployment compensation and recoup costs from the federal government after a delay, creating a temporary drain. Beyond unemployment, most states are increasing spending on public health to varying degrees, providing funding to hospitals, covering educational costs for distance learning, and more somberly, providing meals for those economically displaced. Finally, declines in the value of financial assets will affect municipal pensions, perhaps necessitating greater contributions (although given how rapidly financial markets are moving, the impact is hard to guess). Thus far, only 12 states have adjusted their budgets to reflect higher expenditures.

HOW SOME PLACES CAN COPE WITH ECONOMIC IMPACT

To bridge the gap between lower revenues and higher expenditures, states have several tools. First is "rainy day funds,"” which are fortunately at historically high levels of $77 billion nationwide.

(Source: Janney Investment Strategy Group;National Association of State Budget Officers)

Second is federal aid, which, to reiterate, has measured $150 billion so far with $500 billion more in the works.

Third is borrowing, either from the Fed’s programs or, more likely, through the municipal bond markets. On that count, new issuance is available, as evidenced by California’s $1.4-billion sale on April 16—30-year bonds cost California just 2.36%, though the cost would be greater for small municipalities.

While raising revenues (i.e., hiking taxes) is a longer-term option for bridging deficits, it would probably encourage citizens to bring out the pitchforks in today’s stressed times. In the meantime, borrowing at low interest rates is the best choice for many general obligation (GO) bond issuers.

(Source: Janney Investment Strategy Group; Bloomberg)

High-Grade Muni Yields Much LowerThan Global Financial Crisis Era Means Borrowing

Through Budget Shortfalls is Less Costly

CREDIT QUALITY AT RISK

Ultimately, the question is one of credit quality, not of default risk, for the vast majority of issuers in municipal bond markets. As municipalities drain rainy day funds or borrow to cover budget gaps, the debt they take on will increase the overall risk, leading in some cases to ratings downgrades. Whether this credit deterioration is temporary or permanent depends on the course of the coronavirus spread, pace of economic reopening, and socioeconomic shifts that accompany the economic recovery. Here are a few generalizations:

• Already-stressed geographies and credits face the greatest likelihood of “tipping over” into more severe deterioration. Obvious examples include Illinois, Connecticut, and New Jersey, as well as larger cities within those states. These were the lowest-rated states prior to the COVID-19 outbreak, and all three appear to be near the limit in ability to raise tax rates without inciting population outflows.• Geographies and credits which face a more severe outbreak and longer resulting shutdown will be moreacutely affected. Examples include New York State (New York City), New Jersey, Connecticut, Louisiana (New Orleans), Michigan (Detroit), Massachusetts, and Illinois (Chicago) based on severe cases as a percentage of population as of April 16. A second tier of credits in this category includes tourism-heavy destinations such as Hawaii and Las Vegas, as well as bonds issued via authorities to finance stadiums, convention centers, and similar high-density projects. While these"crowd" revenue projects are a small segment, they often earned A or AA categories based on forecast revenues.

• Transportation revenuebonds might be severelyaffected, though harder togeneralize in this case.

- For public transitauthorities in high-density areas (the largest being the New York’s Metropolitan Transit Authority), the story is mixed. Ridership will be down in these systems for years to come, but these systems serve a crucial community function, particularly for lower- and moderate-income workers. Therefore, while these authorities face lower revenues, we anticipate many will offset declines with reduced capital spending and more reliance on government support.

- Airport bonds areanother sector at risk, although again, the revenue declines in the sector will vary widely. In the short term, passenger enplanements

(passengers pay airport fees, which then repay debt service) are down sharply, and will remain depressed. Airline payments to airports are also down, but CARES Act funding for airlines helps put a floor under those revenues for the moment. Longer term, air travel is an essential national function, particularly for larger metropolitan areas, and airports are likely to receive some degree of federal support, not unlike what happened after the September 11 Attacks. It is hard to estimate how this balance of factors will play out.

- Transit authorities and toll roads are one of the largest transportation sectors. While there is a short-term drop inrevenue from reduced leisure and business driving, there is a reasonable path to recovery as lockdowns ease. For transit authorities that fund revenue bonds with gasoline taxes, low gas prices may provide an excuse to raise revenues even as volumes of gasoline sales are down. There has not yet been a movement to raise revenues in that manner. As with the airports, however, there is an extremely strong national interest in supporting major roadways (think food shipments), and it is reasonable to expect federal support for the sector.

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(Source: Pew Charitable Trusts based on data from Bureau of Economic Analysis, 2018)

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• Colleges and universities issue higher education bonds that are repaid out of tuition and operating income. The structure of the higher education markets is changing, and while state institutions and the top-tier universities and liberal arts schools are well-cushioned against a demand decline, many less-selective colleges and universities may find themselves with reduced student numbers. This same group tends to have thinner endowment cushions, although they do have opportunities to cut operating costs on the margin. Since the changes to the higher education markets are very much a social phenomenon, it is hard to estimate how the credits will fare in the intermediate to longer term.

• Healthcare sector bonds bear perhaps the clearest connection to the COVID-19 crisis, but the story is less positive than one might think. From the early portion of the outbreak, many hospital systems eliminated “elective” inpatient and outpatient procedures (think knee replacements, rather than cosmetic surgeries). These procedures make up a substantial portion of revenue for hospital systems. Larger research-based institutions, meanwhile, have had to slow or pause projects for which they obtain a significant amount of their funding. Sadly, increased hospitalization for coronavirus patients should support revenues to some degree for the vast majority of municipal bond issuers. These revenues, however, are unlikely to exceed the costs of lost elective procedures nationwide. More recently, discussion of Congressional grants has helped support the sector, with $75 billion earmarked for hospital support in the most recent fiscal proposal.

Larger, diversified healthcare systems in the A and AA ratings categories are generally in a better position to offset reduced revenues than are lower-rated single hospital or small regional systems. Ironically, hospitals that support lower income and uninsured populations may also fare better than their counterparts given the social and political movement to support these institutions.

Disclaimer

Past performance is no guarantee of future performance and future returns are not guaranteed. There are risks associated with investing in stocks such as a loss of original capital or a decrease in the value of your investment.

This report is provided for informational purposes only and shall in no event be construed as an offer to sell or a solicitation of an offer to buy any securities. The information described herein is taken from sources which we believe to be reliable, but the accuracy and completeness of such information is not guaranteed by us. The opinions expressed herein may be given only such weight as opinions warrant. This Firm, its officers, directors, employees, or members of their families may have positions in the securities mentioned and may make purchases or sales of such securities from time to time in the open market or otherwise and may sell to or buy from customers such securities on a principal basis.

CONCLUSION

The COVID-19 crisis has tentacles to many areas of the municipal markets.

While the Federal Reserve addressed a short-term liquidity vacuum and fiscal authorities have offered grants to support short-term deficits, fundamental deterioration remains a risk for many areas of the municipal markets.

While we do not expect widespread defaults among high-grade municipal issuers, some credit downgrades are likely. Furthermore, there is a range of sectors with more direct exposure to increased credit risks, from already-stressed states to healthcare facilities. For this reason, and until there is better long-term clarity on economic trends, we continue to recommend an up-in-quality bias when it comes to the municipal markets despite historically low yields.