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January 04, 2021 | GSAM Connect

How Municipalities Can Manage Economic Stress

Periods of elevated economic stress can often show the true resiliency of investments. We think this COVID-19 pandemic is no different. Balance sheet deterioration, widening credit spreads, and illiquidity reflect just some of the many market symptoms that may appear during periods of distress. But for municipalities, we believe there are a number of countercyclical levers available to help stabilize credit quality, suggesting that municipal bonds may prove valuable for a fixed income allocation when times are tough.

Municipal bond issuers benefit from having access to federal funding, budgetary discipline, and diversified revenue streams, all while maintaining rainy day reserves to help buffer against deep economic downturns.

Benefits of Municipal Bond Issuers:

  • Expansionary federal support - This has helped reduce state budget shortfalls. During the Great Recession, federal aid nearly closed all state budget gaps. Over the last decade, state receipts of federal grants-in-aid (federal income tax revenue redistributed to state and local governments) have increased from 19% of total revenues in 1998 to 32% in 2018. In 2020, we expect state receipts to climb to ~40%, expanding municipal access to a growing pool of federal revenue.
  • Budgetary discipline - This means that municipalities have the flexibility to impact both sides of the budget equation – revenues (via taxing power) and expenses (via spending authority). This is important because unlike corporations, municipalities are typically required to strike a balanced budget, so every dollar spent must be accounted for by an equalizing revenue. This practice of tying spending to revenue has helped repair municipal balance sheets in the aftermath of the financial crisis and should help mitigate against possible budget shortfalls in the future.
  • Diversified revenue streams - These can introduce varied revenue cycles that move in opposite direction from one another, which can work in a municipality’s favor. For proceeds like property tax, their lagged relationship with the economy has helped offset weaker proceeds from more cyclically-driven sources like sales tax. Other revenues like fines and fees (e.g., motor vehicle license fees) are often less swayed by the economic cycle. We think this extensive revenue support may prove to be an important defensive characteristic to counterbalance against other income that may be more tethered to the state of the economy.
  • Rainy day reserves - The median US state’s reserves have notched up to 8% of expenditures, reflecting a 30-year high and about twice the size of reserves during the last crisis. The strong security provisions of superior lien and reserve funds provide additional credit support and greater flexibility for municipalities to raise debt.

These multiple defensive features have allowed state and local governments to sustain remarkably low default rates through a variety of economic conditions. As is true of football, in munis the best offense is a great defense.

EXHIBIT 1: PILLARS OF STRENGTH-MUNICIPAL RESILIENCE IN BUSINESS CYCLES

SOURCE: GSAM. As of November 30, 2020. Chart shows the countercyclical fiscal measures available to US municipalities to help minimize economic stress throughout different phases of a business cycle. ‘UI’ refers to unemployment insurance.

We believe the resilience of the municipal complex also extends to periods of legislative uncertainty. Municipals have been the asset class most consistently impacted by elections. However, the impact is rarely binary. To be sure, some scenarios would herald outcomes that are larger (or smaller) in consequence, but as a general rule most legislative shifts incur a one-time, short-lived technical moment for the municipal market. Not surprisingly, we believe the congressional composition from recent US elections is likely to have limited impact on the municipal market in 2021.

 

EXHIBIT 2: POLICY ROULETTE: HOW US POLICY CHANGES MIGHT AFFECT MUNIS

SOURCE: GSAM. As of November 30, 2020. Chart shows the impact of potential policy on the US municipal bond market. ‘State and local tax (SALT) deductions’ refers to the 2017 Tax Cut and Jobs Act that instituted a $10,000 cap on the amount of local taxes that may be deductible on federal taxes. For illustrative purposes only. These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this presentation.

Even in a year with significant political and economic turbulence, municipals have remained fundamentally intact.

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About the Author

John Tousley, CFA

John Tousley, CFA

Global Head of Market Strategy, GSAM Strategic Advisory Solutions

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