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November 10, 2020 | GSAM Connect

A Closer Look at Municipal Credit

This year has been a challenging one for municipalities—and municipal bond investors. After the drawdown in March, we said we thought investment-grade municipal fundamentals were still strong but urged investors to exercise some caution in lower-rated parts of the market. That said we also communicated to investors that higher yielding bonds, with proper analysis, in our opinion may provide strong relative value opportunities as well.   

Since then, though, we have been reminded of the resilience of the muni market. What’s behind the market’s rebound over the last several months? For one thing, state and local governments entered 2020 with sizable rainy day funds after years of conservative budgeting, and that put them in a relatively strong position to manage the downturn. As we move toward year end and beyond, we believe economic growth levels are likely to slowly recover, leading to further uncertainty for municipal investors and issuers alike.  So here are a few things we think that investors should keep in mind:

Don’t Paint with a Broad Brush: Commentators often make sweeping generalizations. The municipal market is not a monolithic entity but a $3.9 Trillion mosaic with tens of thousands of issuers, with nearly one million individual securities1. The market is comprised of states, local governments, counties and tax-backed bonds in addition to relatively stable and highly rated revenue bonds. Issuers can be separated into investment-grade and high-yield entities. Within the investment-grade market, states are highly diversified entities that benefit from diverse revenue sources, conservative budgeting over time and federal aid. In fact, federal aid accounts for roughly a third of a state’s annual revenue and offers a substantial cushion when times get tough (exhibit 1).

EXHIBIT 1: State Governments Have Benefited from Diverse Revenue Sources and Increased Federal Aid Over Time

Source: GSAM, Bureau of Economic Analysis National Income and Product Accounts: Table 3.20. State Government Current Receipts and Expenditures. As of December 31, 2019. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this document.

Stressful Times but Manageable: The initial shock from the impact of Covid-related government shutdowns was significant. However, year-to-date tax receipts through July for the 47 states who report the data show an average decline of just 2.9% compared to 2019, highlighting the diversified nature of state finances. Fourteen states reported growth in tax collections, largely due to the delay in income tax filing and a Supreme Court decision that allows states to tax the sale of all online purchases. While receipts fell significantly from April to May, tax collection has picked up in July due to reopening measures, a resumption of spending and new hiring. When we look back on the current recession, we believe the early forecasts of 10% revenue gaps were overblown. We expect revenue gaps closer to a 5% to 8% range, which should be more manageable2.

Headlines Create Opportunities:  Investment opportunities often arise from temporary market events. While higher-grade municipals continue to offer relative stability and income, opportunities within the lower-rated corners of the municipal bond market remain. But selectivity is important here. For example, hospitals have held up better than many expected they would at the start of the pandemic, when some struggled to handle the inflow of COVID-19 patients. Government help and strong balance sheets have also supported airports, which have seen traffic climb back to ~35% of pre-COVID levels in recent months from a low of 5% at the start of the pandemic. Other sectors, such as university student housing, project finance and senior living, are still facing challenges, making it important for investors to tread carefully.

If nothing else, we see this as a reminder for investors to take the long view and resist the urge to turn away from municipal bonds during difficult periods. Munis are a resilient asset class, and with a hands-on, dynamic approach, we think investors can find value here.


1
Source: Federal Reserve. As of 6/30/2020.

2These 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.

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