Municipals Fixed Income Blog

Unpacking Muni Opportunities in a Slowing Economy

22 March 2023
5 min read
A wall of numbered and well-worn symmetrically square wooden pull-drawers fills the frame
Mirette Kouchouk| High Yield Research Analyst—Municipal Credit
Natalie Laven, CFA| High Yield Research Analyst—Municipal Credit
Bryan Laing, CFA| High Yield Research Analyst—Municipal Credit
Richard Schwam, CFA| High Yield Research Analyst—Municipal Credit

Still shaking off 2022’s dismal returns, municipal bond investors now worry about the impact of a potential economic downturn. Gloomy news reports of projected budget gaps for state and local governments only add to their anxieties. But the muni market is more resilient than headlines suggest, and a closer look across sectors can help discern areas of opportunity from those that require a bit more caution.

Muni Market Resilience Starts at the State Level

Many state and local governments will face fiscal challenges next year, but they inherently have the flexibility to work through them. For example, foreseeing a $22.5 billion deficit due to a slowing economy, California is already strategically delaying funding and shifting spending to close the gap without having to tap into its $36 billion in reserves.

More broadly, the outlook is favorable for most state and local governments, thanks to the record budget revenues and reserves in hand. In fact, the median state reserves-expenditures ratio is currently 25%—well above its roughly 10% over the long run. By contrast, the ratio was just under 12% heading into the global financial crisis of 2008.

Strong fiscal report cards are the linchpin of the muni market’s overall appeal. They also explain why muni bonds have weathered economic malaise much better than corporate bonds. In fact, muni bonds have had fewer downgrades, more stable ratings and significantly fewer defaults—near-zero—compared to corporate issues since 1981, which includes five official US recessions (Display). 

Muni Bond Quality Holds Up Better in Economic Downturns
Municipal Bonds vs. Corporate Bonds
Compared to corporate bonds, munis have had fewer downgrades, stronger ratings and hardly any defaults in the last 25 years.

Past performance does not guarantee future results. 
Data compares the net change in ratings from the first to the last day of each year. All intermediate ratings are disregarded. Downgrade data excludes downgrades to 'D', which is captured separately in the default data. All data is based on nonhousing rating changes.
Through December 31, 2021
Source: S&P Global Ratings Research, S&P Global Market Intelligence's CreditPro® and AllianceBernstein (AB)

Other Muni Sectors Can Benefit from Healthy State and Local Finances

Among the largest beneficiaries of strong state and local government finances are school districts and charter schools—essential services where funding generally takes priority. As a result, they represent muni sectors we think are particularly well positioned for a potential slowdown. Charter schools, for example, receive over 80% of their funding from states with strict constitutional mandates to protect education as a basic right.

Select high-yield muni sectors are well-positioned for a downcycle too. And given their wide spreads, they can also add defensive characteristics and income potential to a portfolio. Current standouts include charter schools, affordable housing and toll roads.

Affordable housing should benefit from rising demand in a downturn. California’s Workforce Housing Program bonds, for instance, play a vital role in the state’s economic growth goals, which are challenged by the lack of affordable housing for middle-income earners. Toll roads have rich cash reserves—enough to carry them through 500 to 1,000 days of disruption—and low labor costs, given the popularity of “easy pass” transponders.

Not All Munis Are Recession Proof

Just as important as choosing opportunities is determining what to avoid. We’re especially wary of the high-yield sectors most vulnerable to economic headwinds, such as senior living facilities, tobacco bonds and land deals.

The senior living sector is suffering through long-lasting effects of the pandemic, including severely weakened demand. A softening housing market is another headwind, since most senior communities rely on entrance fees, which are highly dependent on seniors’ ability to first sell their homes at healthy prices. Combined with staffing shortages and high turnover, we expect senior living credit quality to waver, along with an increase in defaults.

Land deals involve parcels reserved for tract home communities and commercial buildings. Paying back the bonds hinges on selling the completed structures, so we think this sector will weaken if the real estate market softens further.

Tobacco settlement muni bonds are backed by expected payments from tobacco companies to municipalities to reimburse them for healthcare costs related to smoking ailments. Revenues are based on national annual cigarette sales, which will likely decline more than average in a downturn as disposable income shrinks.

Some Muni Setbacks Aren’t Related to a Downturn

Not all muni sector challenges spill from the same well. One very important sector to watch is hospitals, which are under considerable pressure, but not because of a pending slowdown. Rather, healthcare facilities face lingering qualified nurse shortages, which has driven up wage expenses to retain the ones they have. Many facilities are also cash strapped as they push to repay Medicare advances received at the onset of the pandemic.

Balance sheet deterioration across the healthcare sector, which especially struck high-quality issuers in 2022, should subside this year. We also think margins will improve as payor reimbursement rates modestly increase to offset heightened labor costs while patient volume and demand for profitable elective services rise to pre-pandemic norms.

The Fed’s aggressive rate-hike cycle has taken longer than expected to stave off inflation, but eventually the economic engine will slow, and inflation along with it. In the meantime, we’re optimistic about muni market opportunities for the rest of 2023, regardless of where the economy lands. Today’s muni entry point is one of the best we’ve seen in some time, with compelling value across sectors after February’s sell-off and wide spreads among select credit. Yields remain high too, which offers buffering from further increases, not to mention the strongest income potential in years.

While opportunity is knocking, investors should still be selective and stay flexible, as not all munis will weather the storm, when—or if—one starts to build. 

 

AB’s Larry Bellinger, CFA, Director—Municipal Credit Research and Daryl Clements, Portfolio Manager—Municipal Bond Portfolios, contributed to this blog. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

About the Authors

Mirette Kouchouk is a Vice President and High Yield Research Analyst in the Municipal Credit Group, primarily covering the private higher education and charter school sectors. Prior to joining AB in 2021, Kouchouk spent nearly 10 years as a credit analyst at PIMCO in both corporate and municipal research roles. She holds an MBA from the Leonard N. Stern School of Business at New York University and a BS in economics from Tufts University. Location: New York

Natalie Laven is a Vice President and High Yield Research Analyst in the Municipal Credit Group. Before joining AB in 2021, she was a municipal research analyst at Belle Haven Investments and the Hartford Investment Management Company. Laven holds a BA in political science and economics from Southern Connecticut State University’s Honors College and an MPA with a focus in public finance from the University of Connecticut. She is a CFA charterholder. Location: New York

Bryan Laing is a Vice President and High Yield Research Analyst for the Municipal Credit Group. Before joining AB in 2021, he was a senior municipal credit analyst and portfolio manager for Fiera Capital. Prior to that, Laing served as an analyst and manager for the Municipal Credit Data team at Bloomberg. He holds a BS in management from Binghamton University and is a CFA charterholder. Location: New York

Richard Schwam is a Vice President and High Yield Research Analyst for the Municipal Credit Group, with a focus on real estate and project finance. He also covers high-profile general governments and service providers in New York. Previously, Schwam was a vice president and product manager for Fixed Income Business Development, specializing in the firm’s municipal business. He joined AB in 2006 as an associate in the Client Group. Schwam’s experience spans research and investment management, marketing, product development, and business development. He holds a BA in economics from Hamilton College and is a CFA charterholder. Schwam is a Program Committee member of the Municipal Analysts Group of New York and a member of both the National Federation of Municipal Analysts and the CFA Society New York. Location: New York