Macro

Muni Market Faces Early Credit Problems as $4T Federal Aid Sunsets

Municipal bond market faces stress as $4 trillion aid diminishes, with 40% of hospitals losing money and downgrades expected.

By Mackenzie Crow

7/10, 14:04 EDT
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Key Takeaway

  • Municipal bond market faces early credit pressure as federal pandemic aid winds down, with revenue growth slowing and reserve funds declining.
  • Sectors like higher education and healthcare face downgrades, while essential services like water and electric utilities remain stable.
  • Credit rating upgrades outpaced downgrades in 2023 but are expected to normalize in 2024, with a three-to-two upgrade ratio.

Municipal Bond Market Faces Pressure

The $4 trillion municipal bond market is beginning to show signs of stress as federal pandemic aid diminishes. Revenue growth is decelerating, and states like California are experiencing declines in tax and fee collections. Rainy day funds, which had reached record levels due to strong economies and U.S. stimulus money, are now forecasted to decline. Lisa Washburn, managing director of Municipal Market Analytics, noted, “Going into fiscal 2024, we were coming into all-time highs of reserve funds, and the economy had proven to be resilient. If you look into fiscal 2025, you have draw down of reserves and softening of revenue growth.”

While a broad plunge in credit quality is not anticipated, there is expected to be a bifurcation within certain sectors, such as higher education. Municipal Market Analytics has downgraded its outlook for charter schools from neutral to negative. Additionally, 40% of hospitals were still losing money earlier this year, although the firm raised its stance on the sector to neutral from negative.

Conversely, the airport sector and essential service providers like water, sewer, and electric utilities are showing strength. Peter Block, managing director for credit strategy at Ramirez & Co., stated, “The vast majority of credit sectors are stable, although this could change gradually or sharply, especially for lower-rated issuers if the U.S. economy enters a recessionary period.”

Slowing Pace of Upgrades

Credit rating upgrades have outpaced downgrades by almost four-to-one in 2023, but this trend is expected to normalize in 2024. Nick Kraemer, head of ratings performance analytics at S&P Global Ratings, indicated that the pace of upgrades is slowing, with a three-to-two ratio expected in 2024. Local governments have seen the most downgrades, although the sector still maintains a two-to-one upgrade ratio. Utilities, education, and healthcare sectors have experienced net downgrades by S&P.

Arlene Bohner, head of U.S. public finance at Fitch Ratings, suggested that lower inflation could improve outlooks for sectors like not-for-profit hospitals, life-plan communities, and higher education. However, a return to higher costs could exacerbate pressure on municipal bond ratings. Susan Fitzgerald, managing director for public finance for Moody’s Ratings, echoed this sentiment, noting that while upgrades are likely to continue, the ratio may decline as U.S. assistance shrinks and some states face budget constraints.

Nathan Will, head of municipal credit research at Vanguard Fixed Income Group, added, “The vast majority of issuers are well positioned to weather an economic downturn, and more upgrades may occur given rating actions often lag. We would expect that the upgrade trend will slow as the economy cools and the remainder of pandemic aid is spent.”

Private Credit Market Risks

The private credit market, now valued at $800 billion, is under scrutiny as divergent valuations of debts highlight potential risks. The $1.7 billion loan provided to workforce technology company Pluralsight is a case in point. The loan, part of Vista Equity Partners’ $3.5 billion buyout of the company, is now at the center of a messy restructuring. The valuations of this loan by different lenders vary significantly, raising concerns about the inherent difficulty of valuing non-traded loans.

Gary Gensler, chair of the Securities and Exchange Commission, remarked, “I think there’s risks that can build up inside of this private funds world. They are risks that I’ve witnessed personally, like during the Long-Term Capital Management spillovers in 1998.” The private loans rarely trade, meaning fund managers must rely on their own understanding and third-party valuation providers for valuations.

The seven lenders to Pluralsight disclosed a broad range of valuations for the debt, with Ares and Blue Owl marking the debt down to 84.9 cents and 83.5 cents on the dollar, respectively, while Golub valued it just below par at 97 cents on the dollar. This discrepancy poses a problem for investors, who could be misled if a lender or buyout firm has been overly optimistic about its portfolio.

Street Views

  • Lisa Washburn, Municipal Market Analytics (Cautiously Optimistic on municipal bond market):

    "Going into fiscal 2024, we were coming into all-time highs of reserve funds, and the economy had proven to be resilient. If you look into fiscal 2025, you have draw down of reserves and softening of revenue growth."

  • Peter Block, Ramirez & Co. (Neutral on credit sectors):

    "The vast majority of credit sectors are stable, although this could change gradually or sharply, especially for lower-rated issuers if the US economy enters a recessionary period."

  • Nick Kraemer, S&P Global Ratings (Neutral on local governments and utilities):

    "Local governments make up the biggest number of downgrades... Utilities have seen a lot of downgrades while education including charter schools and healthcare currently have net downgrades by S&P."

  • Arlene Bohner, Fitch Ratings (Cautiously Optimistic on not-for-profit hospitals and higher education):

    "Lower inflation could improve the outlooks for sectors such as not-for-profit hospitals life-plan communities and higher education while a return to higher costs could worsen expenditure pressure and in time exacerbate pressure on municipal bond ratings."

  • Susan Fitzgerald, Moody’s Ratings (Cautiously Optimistic on health care and higher education sectors):

    "Sectors such as health care and higher education will face continued credit challenges... The trend of upgrades outpacing downgrades likely will continue this year but the ratio may decline as US assistance shrinks and some states face budget constraints."

  • Nathan Will, Vanguard Fixed Income Group (Cautiously Optimistic on economic downturn resilience):

    "The vast majority of issuers are well positioned to weather an economic downturn... We would expect that the upgrade trend will slow as the economy cools and the remainder of pandemic aid is spent."