TAX-BACKED SECTORS
States
We believe the impact of COVID-19 on state finances will be negative in the near term, while the longer-term effects will depend on the severity and duration of the pandemic. Most state governments derive their revenues from a mix of sales and income taxes, user fees and federal support payments (e.g., Medicaid and federal gas taxes). The impact on each state’s finances will vary, depending on its mix of revenue sources and the impact on economic activity within its boundaries. The IRS has extended the federal tax filing date to July 15, which may delay collection of tax receipts for the 37 states that use the federal tax form as a basis for state tax calculations. Oil- and natural gas-producing states are likely to see a decline in revenues reflecting the pronounced drop in global oil prices. On the expense side, social service costs are expected to increase sharply as unemployment claims spike and Medicaid expenses rise. States with large net pension liabilities are likely to see a jump in those liabilities and a longer-term increase in contribution levels.
Positively, state liquidity and reserve positions are stronger than they were entering the global financial crisis. The Federal Reserve has announced a purchasing program to help states and municipalities with cash flow needs, and Congress, which has already passed enhanced Medicaid funding to states, is expected to provide additional financial support to state governments.
Counties and Cities
We’re maintaining a stable outlook on counties and cities. Our outlook reflects the fact that property taxes, the sector’s primary revenue source, are less economically cyclical than other municipal revenue sources. Gross property tax revenues are generally stable and assessed values are determined with a lag. Further, most local governments maintain rainy day reserves and have a formal budgeting process to address significant deviations in spending. If necessary, some local governments have the ability to increase tax millage rates.
In aggregate, local government credit quality tends to hold up well during turbulent periods. Property taxes were remarkably stable during the previous two significant economic shocks—the global financial crisis and September 11, 2001. However, local governments that rely on economically-sensitive income and sales taxes for a greater portion of their revenue will likely realize more deterioration. State-imposed business and personal restrictions could have a great impact on local government income and sales tax collections. While most local governments do not own or operate hospitals, those that do may have to deal with reduced marginal profitability and liquidity in addition to the costs associated with protecting medical staff. Local governments that own senior living facilities, which typically operate on relatively thin margins, may be forced to deal with increased expenses associated with COVID-19.
School Districts
Our stable outlook for school districts generally reflects the sector’s reliance on property tax revenue. Beyond local property taxes, school districts largely rely on state funding. Because public school districts provide one of the most fundamental and essential services to the public, we think states are unlikely to materially reduce district funding in the wake of school closures due to COVID-19. Many districts have instituted e-learning capabilities and required teachers to communicate with students electronically, further reducing the likelihood of state funding cuts.
REVENUE-BACKED SECTORS
Airports
We expect COVID-19 to have a high impact on the airport sector. Travel demand has plummeted and will likely get worse, with tourism and business travel grinding to a halt and an increasing potential threat of a complete shutdown of the airline industry. The decrease in enplanements could be more severe than after the September 11 attacks and the 2008 financial crisis. The current combination of passenger declines and significant airline capacity cuts has the potential to pressure rate covenants.
Airports’ ability to recover costs through airline contracts may partially offset the negative factors. If an airline breaches a covenant, it would authorize an increase in rates from the airline to facilitate cost recovery. However, financial strain on the airline industry may hinder a full recovery and force airports to draw on reserves. Most airports carry strong levels of liquidity (roughly one-to-two years of cash on hand), which could mitigate downside risk. Recently approved Federal aid to airports and the airline industry is a significant positive for both, providing financial relief and partially supporting projected losses. We believe the ultimate duration of the outbreak and pace of recovery will be key factors in regaining long-term stability for airports.
Convention Centers
Convention center bonds are typically secured by: 1) sales and/or hotel taxes collected throughout a defined geographic region; or 2) lease payments made by a city or state with expectations that local earmarked tax revenues will be sufficient to pay debt service. The spread of COVID-19 has introduced some economic and credit uncertainty, especially for issuers largely reliant on tourism and consumer discretionary spending. The convention center sector and the hospitality industry have seen mass cancellations of rooms, events and conferences, which directly impact sales tax and hotel tax collections.
The economic fallout on the tourism industry could be worse than losses seen following the September 11 terrorist attacks and the 2008 financial crisis. The stronger credits within the convention center sector generally have higher historical debt service coverage levels and reserve funds, which should help them weather an economic downturn and a severe reduction in pledged revenue. Convention centers primarily secured by lease payments of a city or state, subject to annual appropriation, are somewhat vulnerable as these facilities are considered less essential than other municipal facilities. We expect conferences, tourism and business travel to eventually rebound, but at this point the timing remains uncertain.
Higher Education
We are maintaining a negative outlook for the higher education sector, though this is a very fluid situation with many unknowns. Due to the COVID-19 outbreak, most colleges and universities have closed their campuses and are holding classes online. As a result, we believe financial operations, liquidity and enrollment will be pressured in the near term. Student housing bonds may be at greater risk due to students vacating the projects. If closures persist into the summer term, we expect some universities to experience declines in enrollment, especially universities that do not offer robust online curricula during campus shutdowns. Universities with a large international presence may be more vulnerable to shifts in tuition revenue if international student populations shrink. Additionally, if closures persist into the next academic year beginning in fall 2020, declines in fee revenue for other services, such as dining and parking, could have a material effect on higher education bonds. While universities are not typically obligated to refund auxiliary fees, which are paid up front once the academic period begins, some universities may choose do to so in this unprecedented situation.
The sector also faces uncertainty in terms of state support, philanthropic giving and endowment income. State appropriations for public universities are usually the first item to be cut when states face their own fiscal pressures. Philanthropic giving for both private and public universities could also decline due to the increased possibility of an economic downturn. In addition, universities with endowments invested heavily in riskier asset classes will likely experience larger market swings, which would drive a decline in endowment income available for operations.
Hospitals
We have a negative near-term outlook on not-for-profit hospitals and health systems, reflecting uncertainties about capacity, increased supply costs and an expected spike in labor and benefit costs. However, we believe the sector will be more defensive than the broader market and should be a major recipient of emergency federal and state funding programs that are currently under negotiation.
Unlike the vast majority of businesses affected by COVID-19, hospitals and health systems are suffering from an actual and expected spike in demand for services. In response, providers are postponing higher-margin elective surgical procedures to open up inpatient and outpatient capacity for a potential surge in COVID-19 cases. At the same time, providers are incurring higher overtime expenses and increased basic supply costs. Benefit costs are likely to rise materially as many hospitals and health systems self-insure for their employees’ healthcare benefits. Given the reported shortage of personal protective equipment, providers could see their employee health costs rise significantly. However, we believe the impact on profitability will be short-term as the majority of procedures remain medically necessary and are delayed rather than cancelled entirely. Finally, it’s worth noting that not-for-profit hospitals and healthcare providers generally have very strong balance sheets with ample liquidity to fund operations and make debt service payments—a key credit strength compared to their for-profit counterparts.
Ports
With the sharp drop in shipping activity and the strong possibility of a further slowdown, we have a negative short-term outlook for the port sector. Prior to COVID-19, we noted downside risks associated with trade disputes and concern about slowing global economic growth. While we expect COVID-19 to have an adverse effect on shipping volumes, ports’ contracts with terminal operator "tenants" generally include minimum guaranteed amounts irrespective of shipping volumes. However, we are concerned about the possibility of lower volumes aggravating the ability of terminal operators and shippers to make those fixed payments.
Public Power
Overall, we believe COVID-19 will have a low impact on the power sector; as an essential service provider, demand for public power should remain relatively stable. While there may be a temporary decrease in commercial and industrial demand, the effect should be partially offset by the increase in residential demand, with most business professionals working from home. The vast majority of municipal power utilities have unregulated rate-setting capabilities to fully recover operating expenses. This ability should help stabilize the sector even in a severe economic contraction. We expect balance sheets and coverage metrics to remain sound in the long term. However, should local government credits become distressed, the retail electric provider may be forced to transfer additional funds to the local government. The public power sector should continue to benefit from low natural gas prices, which have offered a low-cost alternative to coal generation over the last decade. Additionally, new power-generation projects will likely be delayed until after the outbreak has subsided.
Sales and Income Tax
The impact of COVID-19 is still playing out, but we could see a significant decline in sales tax revenues as consumers put off large-ticket items and cut spending on non-essential items. Commerce has slowed as many restaurants, bars and casinos have closed and sporting events, conventions and concerts have been cancelled. US hotel revenues per available room have declined more than 30% and occupancy rates were down 25% in the week ending March 14, relative to pre-virus levels.i Seated restaurant diners were down 84% nationwide through March 17, and movie box-office receipts are estimated to decline 75%.ii Bonds secured mainly by these revenue sources will be among the most impacted.
As layoffs increase, income tax revenues will decline and unemployment rates will rise from record lows. Further, the federal government has extended the income tax filing date to July 15. Some states have also extended their tax filing date. The delay in tax filing could create a cash flow crisis for some municipal credits—mainly smaller governments that have less flexibility.
Local governments and states that depend on sales taxes and/or income taxes for the majority of their revenue will be particularly hard-hit. The increasing likelihood of a recession could put even more strain on future revenues.
Toll Roads
The economic slowdown should result in significant declines in traffic volumes and toll revenues. We expect those short-term changes in driving patterns to compress debt service coverage ratios. Most toll roads have strong liquidity to mitigate a downturn. However, unlike airports and ports, toll roads are less likely to benefit from postponed commuting trips or from landlord-type agreements that should help ports and airports.
Water and Sewer
We expect COVID-19 to have a low influence on the water and sewer sector. Therefore, we are maintaining a stable outlook. We expect debt service coverage and liquidity to remain solid over the near term. Demand for both water and sewer utilities should remain stable given the essential nature of these services. Capital needs remain elevated within the sector, but strong liquidity and stable revenue streams help mitigate this risk slightly.
Most utilities have rate increases already in place or have rate-setting autonomy, which can provide a cushion in an economic downturn. However, during a downturn, local governments may try to increase reserves by requiring utilities to transfer additional funds to them. We are also closely monitoring the impact of COVID-19 on local governments since the two sectors have a very close relationship.
Endnotes
i, iiJ.P. Morgan, Municipal Markets Weekly, published March 20, 2020.
Disclosure
This paper is provided for informational purposes only and should not be construed as investment advice. Opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted, and actual results will be different. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.
Commodity, interest and derivative trading involves substantial risk of loss. This is not an offer of, or a solicitation of an offer for, any investment strategy or product. Any investment that has the possibility for profits also has the possibility of losses.
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MALR025151
