The first quarter was characterized by a world wide health crisis caused by the first pandemic in the last 100 years. The response to the crisis was to shut down economies around the world. This led to an increase in volatility and a flight to quality rally which brought yields on the 10 Yr UST to new lows below 1.0%. The meltdown in the equity markets beginning in late February accelerated this move as investors sought liquid assets and the safety of UST. High Yield Corporates which are highly correlated with equities posted significant price declines. Munis rallied steadily into early March and then prices collapsed for the next 3 weeks due to forced selling by Muni ETF’s and Mutual Funds. The market then stabilized rallying back to regain most of the quarter’s losses. During this time period quality spreads widened and are still relatively wide compared to levels seen during the last few years.
Review
The table below shows the quarterly performance for a variety of ML indices, and the chart below shows the wild ride Munis took during the last month of the quarter.
The Economy
The economy came to a halt as public gatherings of more than 10 people were restricted and businesses that were not deemed essential were closed in order to help slow down the spread of the virus. These were drastic measures instituted in response to the pandemic. There is no question that we are currently in a global recession caused by a pandemic event. This has put stress on the economic systems around the world. As unemployment has risen at an unprecedented pace governments have been quick to respond softening the economic blow to individuals and businesses. However, there is uncertainty as to how long this crisis will last, and how quickly the economy will recover.
The current situation is much different than the Financial Crisis which was caused by excessive leverage at financial institutions and the collapse in real estate prices. After the crisis in 2008-2009 restrictions were imposed on banks which limited the amount of leverage in our system. Banks entered this event in much stronger shape than in the last recession. Recessionary pressures are most felt by those that are over leveraged and don’t have a “rainy day fund” to help them weather the storm. The longer negative conditions last the more damage is done to these companies and individuals. The good news is that governments are sympathetic and are taking steps to help those that need it most.
Impact of the Pandemic on Municipals
Questions are being asked about the impact on public sector finances caused by the current crisis. The economic impact of the pandemic will not affect all Muni bonds the same. A bond is essentially a loan to the issuer. Each bond has some sort of tax or revenue which secures the interest and principal payments on the bond. Some revenue sources are more stable than others. For example, a local school district bond that is secured by property taxes is less likely to default in an economic downturn caused by social distancing than a bond secured by fares to ride the subway or car rental fees. The table below shows which types of bonds will be the most negatively affected by the current economic slowdown. We have typically avoided bonds which are for hotels, convention centers, and casinos. We have had a much stronger preference for bonds which fund K-12 education. These bonds have a strong public purpose and are much more stable in an economic downturn.
CARES Act
To help the Municipal sector, small businesses, and individuals Congress passed the CARES Act legislation.
Congress passed the CARES Act on March 30, 2020. The details of the act which relate to helping municipalities are shown below.
Financial System Liquidity Fund A $454 billion "Economic Stabilization Fund" that permits the US Treasury to "purchase obligations {of States, local governments, instrumentalities and political subdivisions of them} or other interests in secondary markets or otherwise" thus permitting the Federal Reserve to participate as an institutional investor in securities that mature in greater than 6 months. This fund also provides loans and loan guarantees to small businesses.
Covid-19 Relief Fund $150 billion in direct aid specifically for COVID-19 related expenses to states, tribal governments, territories and local governments over the population of 500,000 people.
Hospitals $130 billion in grants to health care providers to provide reimbursements and to supplement lost revenue to hospitals
Education $30.9 billion in grants for education for states, local school districts, and colleges and universities.
Fema $45 billion for FEMA. The funds are intended to help state and local efforts, including medical response and purchasing protective equipment. The breakdown includes: $200 million for shelter, food and services; $100 million in grants to firefighters for protective equipment, supplies and reimbursements; $100 million for enhanced sanitation at airport security checkpoints and other airport costs.
Public Safety $100 million will go to correctional officer overtime, personal protective equipment and supplies, and inmate medical care and supplies. Another $850 million is designated for state and local law enforcement and jails through a grant program.
Transit Providers $25 billion for transit providers through Federal Transit Administration (FTA) Transit Infrastructure Grants. Including states and local governments across the country, for operating and capital expenses. Funding will be distributed using existing FTA formulas.
Airports $10 billion to maintain operations at our nation’s airports that are facing a record drop in passengers. Airport Improvement Program funds will be distributed by formula according to the Federal Aviation Administration.
Source: CARES Act, MMA, & TFS
The Fed
The Fed has acted in concert with Congress to help the Pubic Sector by creating a liquidity facility for Munis.
Municipal Liquidity Facility
On April 9, 2020 the Federal Reserve established the Municipal Liquidity Facility to help state and local governments manage the cash flow stresses caused by COVID-19.
Federal Reserve Bank will lend to a special purpose vehicle (SPV) on a recourse basis.
For the next 6 months the SPV will purchase up to $500 billion of Short Term debt issued by the eligible state and local borrowers.
The Reserve Bank will eventually be repaid by the state and local borrowers under the terms of the debt instruments.
Further, the Reserve Bank will be protected against losses via a $35 billion equity investment from the U.S. Treasury under the provisions of the CARES Act.
State and local borrowers can access the facility through several types of debt instruments including TANs, TRANs, BANs that must be repaid in 24 months. States are able to help political subdivisions by using the proceeds of the notes to purchase similar notes issued by Cities or Counties within their state. Proceeds of the borrowing can be used to manage the cash flow impact from the extraordinary expenses and revenue losses caused by the pandemic health care crisis, including tax filing delays and DS payments of other debt. The purpose of this facility is to enable municipalities to continue to function and provide services to their taxpayers during the pandemic. Issuers will have more time to adjust their budgets, use reserves, or secure other ST financing to manage financial pressures in order to pay back these loans within the required two year period.
Source: Federal Reserve
Conclusion
The efforts to contain the current health crisis are creating stress in the financial systems around the globe. However, this pandemic will not last forever. Test kits are being created to help detect those who have the virus. There is considerable research being done to develop drugs to treat the virus and to develop a vaccine to prevent the virus in the future. The economy will begin to recover as the current health crisis dissipates. It is difficult to know how quickly this will occur.