After peak, muni credit, ratings face economic headwinds

Bonds

Municipal credit quality has reached its peak and several sectors are vulnerable to stronger economic and political headwinds that are likely to impair credit and rating trends for the rest of 2022 and beyond.

This is according to a report from Municipal Market Analytics, which revised down its credit outlook for several sectors including hospitals, pubic power and airports, noting that looming credit trouble in the second half of the year may underpin a bleak credit and operating situation for issuers in the next two years as macroeconomic problems grow and a potential recession is on the horizon.

MMA changed forecasts for market sectors it believes are “most immediately and directly affected” by record inflation, financial market volatility, rising rates, deteriorating consumer credit and confidence, lagging corporate profitability and supply chain issues.

MMA noted that smaller regional airports will likely suffer the most severe consequences of a deteriorating credit environment, as the rising cost of development projects may necessitate increased borrowing. 

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“Our expectation is that, at a minimum, these challenges will widen the credit quality gap within the affected sectors, although price and performance spreads — still glued together by tax-exempt product scarcity and very low current default rates — are unlikely to fully signal this dispersion,” MMA said in a report Monday.

Others in the industry say that municipal credit may be at its apex.

“We’re probably at the peak of the strength of the fundamental credit in the muni market,” said Peter Hayes, head of municipals at BlackRock. “Now, that’s from a very high level. I don’t want to extrapolate that across the whole market.”

“But I think the big issue is going to be more about the bifurcation of credit that will occur in the market over the next couple of years,” Hayes said during a Bond Buyer Leaders session Thursday. Fundamental credit research, he said, “is going to be all that more important. And if we go into a much weaker economic environment, there’s clearly going to be some areas that suffer more than others.”

Worsening sector outlooks may stretch into the first half of 2023, MMA said.

Ongoing capital projects within some of the impacted sectors will require more dollars and resources, which may result in increased borrowing or projects being scaled back, according to MMA. Other sectors face challenges linked to growing climate-related concerns, ranging from the effects of climate catastrophes, the possibility of stricter climate policy and the high costs of updating existing infrastructure to adhere to sustainability standards.

The seven sector outlooks revised by MMA were airports, hospitals, state credit, tobacco, Industrial Development Banks, water and sewer, and electric, gas and power. 

Of the seven, two were either changed to or trending negative, two were changed to neutral and three remained positive but with weakening conviction from the firm.

IDBs had the only credit outlook MMA changed to negative, citing “tighter high-yield credit conditions” combined with current widespread economic challenges, with “rising insurance costs related to climate risks” potentially exacerbating the situation.

Hospitals are trending negative according to MMA, due to rising labor costs and shortages, record inflation, supply-chain issues and “less lucrative service mix as outpatient services rebound from the pandemic more quickly than in-patient admissions and emergency room visits.” And with federal aid from COVID bills and investment performance drying up, hospitals are losing two additional channels of funds that have kept them above water since 2020. 

“On the horizon, the sector also faces pressures related to the downstream risks of expiration of enhanced Medicaid funding and enhanced ACA subsidies that could negatively affect payments to providers and increase the uninsured population and uncompensated care,” according to the report.

MMA shifted its credit outlook for the electric, gas and power sector to neutral with inflation and rising food and energy costs amplifying pressure on consumers to meet bill payments, which, in turn, is jeopardizing the liquidity and financial performance of the sector.

“As always, utilities with highly concentrated or smaller customer bases are the most vulnerable to surprise distress, but many utilities could see rating trajectories tempered, and political support from sponsor governments undermined, if fuel prices remain high,” MMA said.

The tobacco sector’s outlook was also revised to neutral, which MMA noted, was due mostly to the “highly positive debt restructuring cycle” the sector underwent over the last few years, coupled with growing inflation and the burgeoning possibility of a recession likely to decrease cigarette use.

MMA loosened its conviction on a positive outlook for a few sectors, including airports, due to rampant inflation, fuel and labor concerns and a looming economic downturn jeopardizing the gains made during the industry’s gradual first-half recovery. The report added that smaller regional airports will likely suffer the most severe consequences of a deteriorating credit environment, as the rising cost of development projects may necessitate increased borrowing. 

Scott Monroe, senior director of Fitch Ratings’ global infrastructure and public finance group, noted the transportation sector as a whole is poised for a stable credit environment in the second half and into next year, attributing it to “robust” debt service coverage ratios and a “decent” rate of liquidity. 

But Monroe expressed concern for sub-sectors within transportation, such as discretionary and leisure travel, which are more vulnerable to the consequences of rising fuel prices.

“Think about taking the car out and driving to grandma’s on Thanksgiving who might live far away, perhaps a family would stay home, or if high energy prices filter into high airfares, maybe not take that Hawaiian vacation that they have to fly to,” Monroe said at a Fitch Ratings webinar Wednesday.

State credit and water and sewer sectors also retained their positive credit outlooks, but not without some weakening conviction from MMA.

“Two of states’ three main tax revenues — personal income taxes and corporate income taxes — and federal transfers are at risk of underperformance because of economic softening, investment market performance, ill-timed tax-cuts, waning pandemic-era federal aid, and expiration of enhanced transfer payments,” according to MMA.

The water and sewer sector is challenged by greater electricity costs and growing problems with labor conditions. Its outlook is also impacted significantly by environmental factors, according to MMA, as the sector is caught between the possibility of stricter climate policy being passed and the high price tag of updating existing infrastructure to address operational and sustainability concerns.

The firm is also monitoring closely the 2023 sector outlook of charter schools, higher education, local housing, pre-refunded, sales and special tax, state housing finance agencies and tax increment finance and tax-anticipation-related credits.

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