Municipal Credit: Why Haven’t There Been More Downgrades?

Written by: Sarrah McFadden

Rating agencies have garnered headlines recently regarding the lack of significant municipal downgrades during the pandemic. Opponents question why, with economic and financial deterioration, have the rating agencies not taken swift and sharp action on the underlying ratings of municipal borrowers? Ratings have remained largely intact for two reasons. First, agency ratings are designed to consider operating performance as well as the issuer’s financial and budgetary ability to manage unexpected market shocks. Second, the federal government’s Coronavirus Aid, Relief, and Economic Security (CARES) Act provided much needed funds for state and local governments, as well as the healthcare, education and transportation sectors.

Determining a rating entails a host of procedures, including evaluating the economy, reviewing multi-year financial analyses, and looking at the strength of the reserve position and the ability and willingness of management to make budget adjustments. When stay-at-home orders were at their peak, municipal credits experienced significant revenue declines alongside increased COVID-19 expenses. To call this unprecedented is an understatement. However, what makes municipal debt unique is the arsenal of tools at management’s disposal to reduce fiscal pain, all of which we saw deployed over the short-term: spending and hiring was frozen, short-term bond anticipation notes and lines of credit were accessed, and debt was restructured. For longer-term fiscal stability, other measures are being implemented: taxes are being increased, capital plans put on hold and longer-term staffing needs are being evaluated.

As time passes, some credits are experiencing a rebound, supporting the rating agencies’ lack of immediate rating action and their measured approach. For example, some hospitals are reporting increases in patient volumes, while state, local and county sales tax revenues are improving as the economy reopens. Take Cuyahoga County, OH, home to Cleveland. Both Moody’s and Bloomberg note the county expected a 20% drop in sales and tax revenues for fiscal 2020. Halfway through the fiscal year, June sales tax is trending at only a 1.6% decline over the prior year. For rating agencies to have acted in the first few months of the turmoil would have been reactionary, not allowing time for revenues to rebound and budget adjustments to take effect.

Another factor driving the lack of significant rating action is funding from the CARES act, signed into law by President Trump on March 27, 2020. CARES provided aid payments to state and local governments, hospitals and industries negatively impacted by COVID-19. A temporary $600 weekly increase to unemployment benefits also helped keep the economy churning. This was a much-needed boost to the balance sheets of various entities.

After extended debate, a Phase Four stimulus package with aid to government entities has yet to be passed. While municipal issuers would certainly benefit from another package, further delays won’t necessarily translate to a sharp deterioration in credit quality. Downgrades will occur, but those most impacted will be credits that already have weaker operating or financial positions entering the recession. The majority of credits entered the recession from a position of strength and were helped along the way by the first stimulus plan. To maintain credit quality, it is now up to management to make tough budget decisions and prudent use of these rainy-day-funds to get through the COVID-19 storm.

Sources:  Bloomberg as of 9/15/20 and Moody’s as of 08/14/2020

Related: The Federal Reserve’s Inflation Shift