In order to effectively protect capital, we must ensure that our credits remain money good through a wide variety of economic and political circumstances… and what better test than 2020? Never before have we experienced a Great Depression-like economic contraction coupled with a public health crisis, social unrest, and political disorder – all at the same time.
Amidst this backdrop, concepts such as sustainability and social consciousness have been resonating with investors more than ever. Much of the emphasis prior to COVID-19 was on environmental concerns like clean energy and emissions targets. Governance issues such as improving transparency were another major consideration as investors demanded more thorough and timely disclosures.
Now we are seeing a pivot towards social concerns. Core to the social pillar of ESG is the sustainable provision of services, what we call “service solvency”. A municipal government or enterprise exists to provide core essential public services, such as public safety, health, and education. To do so, it must hire and retain workers at a fair wage. And it must do all these things, as well as service its financial obligations, while preserving affordability for its community. But what does that look like in the face of COVID-19?
The pandemic’s impact is widespread, and beyond its tragic human cost, it is wreaking financial havoc throughout the nation. Issuers from all corners of the municipal market face challenges, but the resources and flexibility for effectively handling them vary greatly. While we never explicitly considered a global pandemic when underwriting a credit prior to last spring, we always used conservative standards and punitive “what-if” scenarios. Remember, capital preservation is job number one for us. This left us prepared, holding a portfolio that was well-positioned to weather the proverbial storm.
For a bond to be well-positioned to withstand an unprecedented event such as the coronavirus, the taxes or revenues backing it should exhibit four key characteristics: they should be broadly defined, less cyclical, geographically diverse, and derived from an esential purpose or project. State governments received significant negative press throughout much of 2020. While all states maintain a public health infrastructure, none were adequately equipped to handle a deadly pandemic. States were required to develop policies to manage new and unprecedented social considerations in fighting the virus, such as establishing testing and tracing protocols and quarantine rules. Other tough policy decisions impacted schooling and the parameters by which “non-essential” businesses could operate, if at all.
Despite these challenges, we believe the negative headlines were largely undeserved from a credit perspective. We are pleased that estimates of revenue shortfalls have steadily declined since last spring and the money states are slated to receive from the American Rescue Plan Act will provide welcome replenishment Still, state governments will face tough choices balancing the funding of essential services while the need to balance their budgets. They have numerous levers to pull, including spending down reserves in their rainy-day funds, borrowing, or raising taxes if necessary. Furloughs, layoffs, education funding cuts, and capital spending cuts or delays are all commonly used to lower expenses, albeit with social impact.
State general obligation (GO) bonds provide an effective contrast to credits that are less resilient to a major disruption. These credits are typically backed by tax bases or revenue streams that are more narrowly defined, cyclical, geographically concentrated, or derived from non-essential projects, which heightens their sensitivity to social risk factors. Examples include dedicated tax bonds backed by hotel taxes which have faced dramatic declines in tourism, or local sales tax bonds with a concentrated economic base. These bonds may have been issued for non-essential purposes such as sports arenas or shopping malls. This lack of essentiality presents a threat to both stakeholders, who may face higher taxes, and bondholders, who could face an issuer with less willingness to pay if times get tough.