Anyone who tells you they are an expert in finance is being a little deceitful. Even the so called experts are specialists in an area of finance, not everything. It’s like saying someone is an expert in science, a cell biologist has a different expertise than a astronomer. As with academia, it pays to be curious and learn from other disciplines under the umbrella. One of these areas I have been learning about recently is municipal finance.
When I think of municipal finance, I think of the bonds of states and maybe cities and the fact that they are, for the most part, tax free. Municipal bonds are not those just issued by states, cities or counties though, it’s an umbrella designation that entails everything from hospitals, universities, toll and bridge infrastructure, airports and even sports stadiums. They can be secured or unsecured and can be backed by taxes or revenue that derives from for profit enterprises, the most is pretty wide.
The Market for Municipal Bonds
You would think that non-profits don’t have much to do with your portfolio but if you understand a little about the municipal bond market, you may start to realize that you may be unknowingly backing some non profits if you own a mutual fund or ETF which purchases municipal bonds. To help to understand why, it helps to give a broad overview of the municipal bond market.
The US bond market is worth about $45 trillion dollars in total as of December 2019. Of that, $18.5 trillion is federal government or agency debt which is the largest segment. After that mortgages related debt comprises over $10 trillion followed by corporate debt at $9.6 trillion. The municipal bond or “muni” market comes next in size at $3.8 trillion, about 60% smaller than the mortgage or corporate debt markets.
Source: UBS
The key distinction compared to the other US debt markets mentioned is the diversity and low liquidity of the muni market. There are more than 50,000 borrowers and over 1 million different security types. That’s 5 times more issuers than the entire corporate debt market and 33 times more types of securities. Less than 0.3% of municipal bonds are traded on any given day. This is even less liquid than corporate bonds which tend to be considered illiquid and much less liquid than treasuries.
More than any other security, municipal bonds tend to be bought and held to maturity by households. Households hold almost 50% of all the muni bonds outstanding. It’s the one area of the bond market that institutions do not dominate. There may be broker dealers, who funnel the bonds to buyers but buyers like to hold their muni bonds.
The one exception to this is periods like the present when there is high volatility. The second largest holders of muni bonds are mutual funds and in periods of volatility, investors rush to sell their mutual fund shares which is called redemption in the mutual fund world. When this happens the portfolio managers have no choice but to sell their muni bonds. This produces a flood of liquidity to a market which is normally illiquid and prices can fall fast. Particularly if it’s a borrower that is in distress, it can be difficult to find buyers and lead to further price reductions.
What this means is that across the muni spectrum, volatile times may produce good opportunities for adept muni bond investors, as long as you stay away from the trouble spots. To help keep you out of those trouble spots, I want to look at 2 areas of muni finance that are under pressure due to coronavirus and how they may affect your muni bond portfolio if you own a fund or individual bonds.
Buying Into Non-Profits
It makes sense that public universities are able to issue muni bonds. They are assisted with state revenues, provide a public service in educating the population and they also provide support to local communities through industry spillover effects and direct jobs on the campus itself, but did you know that private universities are also large issuers of muni bonds? Within the private university space, there is a hierarchy just like any other market. The most famous and prestigious private universities are able to issue at very low rates and exceedingly long tenors. Last year the University of Pennsylvania, Georgetown, Rutgers and the university of Virginia issued 100 years bonds that totaled $1.23 billion. These were quickly snapped up by insurance companies that like to lock in higher fixed returns over long periods of time, especially in this low rate environment.
Outside of the well known and prestigious universities, who have market pull and brand power, there are hundreds of small private colleges that may issue municipal debt, and many of these colleges are in trouble. The reasons are not complex, there are too many schools chasing too few graduates. Colleges depend on a steady supply of high school graduates who can afford the expensive tuition they charge. Right now the national figure for high school grads is flat and projected to slightly decrease over the coming years.
This is just the national picture however, certain states have been seeing an outflow of people overall over the past few years which has mostly been affecting states in the Northeast and Midwest. The situation for colleges looks much worse within these states, just take a look at the projected high school grad pool for Connecticut.
That’s about a 1% drop in their potential pool overall every year. It’s one reason why US colleges have been marketing themselves overseas to make use of their reputation as the most expensive colleges in the world to attract wealthy international students to attend. Covid-19 however may upend this strategy and place universities that were already in trouble in dire straits.
There was already pushback in terms of the increasing cost of college. Ballooning administration, unnecessary luxury student facilities and increased remote learning were all pressing up against the exercise of annually increasing tuition to pay for it all. Once Covid-19 hit, endowments fell, in person classes were cancelled and many start to question why they are paying so much if they are not using the expensive infrastructure of the universities. One study even predicted 25% of colleges will “fail” in the next 20 years, the virus will surely accelerate this phenomenon.
This will spill over to the municipal bonds some of them have issued. Although these bonds may make up about 5%-6% of the bonds that make up a fund that tracks the Bloomberg Barclay’s Municipal Bond Index, you will want to be sure your portfolio manager has a handle on what exactly she is holding in terms of the education portion.
Source: Schwab
Issuers that may see some vulnerability include Drexel University, Emerson College and Howard University.
Hospitals Making Cuts
Another segment of the market that may see stress is the healthcare segment. Municipal bonds are issued to build and upgrade hospitals, but our for profit model of healthcare doesn’t always align incentives for the type of care we need. For example, coronavirus treatment is necessary but is not particularly profitable compared to the elective surgeries that hospitals perform on a daily basis.
Hospital bonds depend on the revenue that the hospital generates and many hospitals generate a large part of their revenue through these elective surgeries which have either stopped or dramatically slowed down as hospitals shifted towards treatment of coronavirus patients during the pandemic. This is where the profitability of hospitals and the sociological impact of the pandemic meet. Due to having to be physically at their jobs, many more blue collar workers are catching the virus compared to white collar workers who may have the option to work from home. Due to gaps in the healthcare system, many of these workers depend on programs like Medicaid as their means of health insurance. This is good for the individual but less revenue for hospitals, which means they are dedicating expensive resources towards low income business. If the staff handled expensive elective surgeries only, they may see furloughs or layoffs themselves. Elective doesn’t mean unnecessary, elective surgeries include cataract surgery, mastectomies for breast cancer or kidney replacement from a donor. This has led to the ironic development of hospitals losing money or facing closure altogether for the jumó in treatment needed for coronavirus.
Hospitals make up around 9% of that Bloomberg Barclay’s Muni bond index mentioned above. Couple that with the education sector and you have about 15% of the entire index in a sector of the muni world that is going to be under direct stress due to the coronavirus not just in the near future but in the coming years as well.
Conclusion
Universities and hospitals are not the only non-profits that matter either, what has gone underreported in the mainstream media is that non-profit institutions are facing the same headwinds that many small businesses are. Some have resorted to the PPP loans that are keeping some firms afloat during the lockdown. Apart from a muni bond portfolio, we could see more non-profits closing shop if the lockdown continues which would lead to repercussions from everything from art galleries to blood banks. It’s another reason that opening up at least some parts of the country are becoming ever more crucial as the failure institutions will force politicians to make choices that no one wants to make: more people dying from lack resources due to Covid-19 or more people dying directly from Covid. Knowing where these impacts will show up first is a a step in making those hard decisions.
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