Amid the drumbeat of dark predictions about the economy, why are municipal bond investors sanguine?
It’s simple: They’re confident they will be repaid.
While that may seem strange amid talk of an imminent recession, a deeper look explains why.
First questions
When muni investors analyze bonds to purchase, they recognize they’re making a loan. So the first questions they ask are, “Who will pay me back?” and, “How strong is the payer?”
And when they look at the fiscal condition of states – which accounts for a lion’s share of the municipal bond market – they feel assured.
As we have pointed out (“The Ballast Behind the Muni Market”), unprecedented assistance from Washington in the wake of the coronavirus pandemic, strong growth and healthy revenues have swelled state coffers.
“States’ financial health is its strongest in decades,” declared AllianceBernstein, in a recent report.
States’ total fund balances hit a record $343 billion last year, while rainy-day funds reached $134.5 billion, also a record, the report said.
“In fact, states have more reserves today than just before 2008’s global financial crisis,” AllianceBernstein said, adding that strong states help other issuers, too.
“Local municipalities – such as cities, counties and school districts – directly benefit from financially sound states, too, since healthier states are less likely to crimp monetary aid to them.”
Revenues soared despite pandemic
Despite the pandemic, tax revenues have been robust. From January 2020 through the end of most states’ 2022 budget year, tax revenues outperformed their pre-pandemic growth trajectory in a record 32 states, according to an analysis by Pew Charitable Trusts.
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By the end of 2022’s second quarter, total state tax revenues were at their highest level since just before the historic decline in early 2020, Pew said.
“Nationwide, and in 32 states as of the end of the second quarter of 2022, cumulative tax receipts since the pandemic’s start, adjusted for inflation, were even higher than they would have been if pre-Covid growth trends had continued – despite fallout from the pandemic and a two-month recession,” Pew reported.
However, Pew also said it sees state tax revenue growth approaching a possible inflection point. It notes states must navigate several looming challenges, including slowing revenue growth as the economy weakens and monetary policy tightens, historically high inflation and less federal Covid aid.
To be sure, state revenue sources vary. Some rely mostly on sales taxes while others depend heavily on income taxes. Should there be a slowdown, states may experience the fallout differently.
However, there are good reasons why no state has defaulted in almost 100 years: They possess unique powers to cope with shortfalls, including borrowing, taxing, delaying or eliminating programs and using cash reserves.
AllianceBernstein points to California, which expects its revenues to drop this year. Instead of tapping its budget reserves to close the expected deficit, the state plans to postpone spending on previously scheduled projects.
Focusing on what’s important
While news from a critical cog of municipal finance is encouraging, it doesn’t replace the need for investors to always do their homework and focus on the fundamentals driving their decisions.
It does, however, help explain how they sleep soundly at night as their interest clock keeps ticking.