(Bloomberg) -- Municipal bankruptcies are becoming a distant memory for tax-exempt bond investors thanks to the strength of US state and city balance sheets. Some strategists warn the sunsetting of federal aid may ratchet up credit fears.
Wednesday will mark a record 449 days since Hazel Hawkins Memorial Hospital filed for Chapter 9 protection on May 23, 2023, surpassing the previous longest stretch from June 2021 through September 2022, Bank of America Corp. analysts advised in a note last week. And it’s been seven years since a bankruptcy-like filing for Puerto Rico rocked the market, as similar events by Jefferson County, Alabama, Detroit and Orange County, California, had in past decades.
Investors continue to flock to the muni market, helped by solid returns and improved issuer creditworthiness. State and local governments for the past few years have been buoyed by hundreds of billions in federal dollars allocated to provide financial stability during the pandemic era.
“We’re in a very strong credit cycle right now,” said Arlene Bohner, head of U.S. public finance at Fitch Ratings. “Not every local government is in a stronger position today than they were before the stimulus but on the whole most governments are.”
Thirty-eight states amassed record rainy day funds at the end of fiscal year 2023, according to data from the Pew Charitable Trusts. Moody’s Ratings logged its 13th consecutive quarter in which upgrades outnumbered downgrades in the first quarter of the year, with similar reports coming from Fitch and S&P Global Ratings.
Even the persistent inflation that’s caused a jump in the price of goods and some wages turned out helping municipal budgets, bringing higher government revenues from sales taxes and personal income taxes.
“We always talk about inflation as a bad thing but from a revenue perspective for a government it’s a good thing,” said Jennifer Johnston, director of research for Franklin Templeton Fixed Income’s municipal bond team. “The position has really helped credits absorb the challenges of inflation.”
Challenges Ahead
Some analysts see reasons for concern. While Tuesday’s inflation report bolsters market expectations for a Federal Reserve interest-rate cut next month, the central bank’s rate increases the past few years have squeezed some borrowers.
And lower inflation will reduce any bonanza to higher local tax revenue. Plus, federal aid to combat Covid is scheduled to run off.
“Now what’s going to be important to watch is what happens over the next three to four years,” said Johnston, pointing to measures such as reserves, cuts and revenue enhancements that governments will have to deploy in order to meet budget gaps.
In fact, US states already are cutting back on spending at a pace not seen in more than a decade, though about half still plan to increase expenditures in fiscal 2025.
“We do not necessarily agree that all is okay with municipalities,” said Eric Kazatsky, senior US municipals strategist at Bloomberg Intelligence. “Spreads are widening, our sentiment tracker is flashing red and tax collections are slowing as stimulus funds are down to zero.”
For now, though, the performance of municipal bonds is such that investors can’t ignore the market, particularly since the threat of defaults and bankruptcies is diminished.
“You’ve gotten some of the cheapest valuations across the fixed income space, extremely high credit quality on the back of post-pandemic fiscal aid, as well as strong tax revenues from a healthy economy,” Paul Malloy, head of municipals at Vanguard, said in an interview. “When you bring those two things together — of strong fundamentals and still attractive valuations — it’s the best game going right now.”
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