Severity of downgrades to US municipal credit hangs on US election outcome, finds Breckinridge

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Municipal bond issuers in the US are likely to face credit rating downgrades over the next several quarters, according to fixed income manager Breckinridge Capital Advisors, who says their severity may depend on the outcome of the US election.

State and local government budgets have come under pressure this year due to the lower state tax revenues caused by the coronavirus crisis.

The latest forecasts from The Center for Budget and Policy Priorities (CBPP) anticipate state and local budget deficits of USD445 billion from 2021 to 2022, while Moody’s expects state tax revenue to be 11 per cent lower in 2020 than it was in the previous year. 

Breckinridge’s senior vice president and co-head of research, Adam Stern, notes that “municipal credit quality has deteriorated less than expected since the Covid-19 pandemic began”. 

Forecasts from CBPP and Moody’s have both been revised upwards from their initial projections in April, when budget shortfalls of USD540 billion were predicted alongside severe state tax revenue declines of 15 per cent.

“A combination of loose fiscal and monetary policy, and improved adaptation to Covid-19, has contributed to modest credit stabilisation in some corners of the market. More fiscal stimulus and a continued improvement in virus-management is necessary to maintain the market’s nascent credit recovery and avoid an acceleration in ratings downgrades,” says Stern.

Nevertheless, Breckinridge notes that the first nine months of the year saw 60 municipal bond defaults, which is the highest total in seven years, and both Moody’s and S&P maintain a negative outlook on all public issuers, except for utilities and community colleges.

“We find that ratings downgrades are likely regardless of the federal response,” says Stern, although he considers that additional federal aid would “reduce fiscal pressure”. 

“Against this backdrop, the results of the November 2020 elections are important for credit and valuations.”

The US election is due to be held on 3 November, and pollsters at FiveThirtyEight give Democratic candidate Joe Biden an 88 per cent chance of victory over Donald Trump. 

Stern continues: “In the most probable outcome, a Democratic sweep, meaningful direct federal aid is likely, as well as tax hikes. This combination bodes well both for credit and for valuations. In other scenarios, federal support is likely to be less robust.” 

This would make the passing of a version of the HEROES Act in January or February more likely, which includes Pandemic Unemployment Assistance of USD600 per week, direct payments to individuals of up to USD1,200, and over USD900 billion in direct federal aid for state and local issuers.

If Trump wins, Stern warns that while meaningful stimulus spending may improve municipal credit fundamentals, there will be less direct support for state and local issuers.

“Municipal ratings are likely to have a downward bias for the next several quarters. The 2020 election cycle is, therefore, likely to impact the muni market. Breckinridge remains very comfortable with our credit exposure given our high-grade bias and longstanding bottom-up approach to credit. We anticipate a challenging, but manageable, next several months,” says Stern.

Stern adds that municipal ratings and credit fundamentals entered the pandemic on strong footing, and that 48 per cent of S&P’s investment-grade public finance ratings are presently AA-minus or higher, and 44 per cent percent in the A category, while only 6 per cent are BBB.

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