Analysts expect pockets of credit deterioration in 2024

Bonds

Muni market participants and analysts expect certain sectors and subsectors to experience credit weakness and the U.S. presidential elections and federal policy potentially having major impacts on the municipal market this year.

The Bond Buyer released survey results in a report titled, “After two stormy years, munis face still more uncertainty,” which detailed predictions and concerns at the top of mind of various market participants.

The professionals think interest rate changes will be this year’s biggest market challenge, according to the survey. Yet they diverged as to where they thought the rates were headed. A majority of those surveyed believe the Federal Reserve will start cutting rates in 2024, with 16% of respondents saying they expect cuts to start in the first half, 43% saying reductions will come in the second half, 35% saying there won’t be any cuts, and the rest did not offer an opinion. 

“I think you will see muni rates mark time in the beginning of the year — maybe drift a little higher,” said John Mousseau, chief executive officer of Cumberland Advisors. ”But as the economy slows some, and the bank problems with real estate come more into focus, and inflation continues to ratchet down, I think interest rates in general should move somewhat lower. Muni yield ratios to Treasuries are already low so there may be some drift higher with additional supply but in a market moving towards lower overall rates.”

Mousseau added he expects the Fed will cut short term rates slowly.

Interest rates “are more likely to be an opportunity than a challenge,” said Juliet Stiehl, east region head of public finance for Build America Mutual, which sponsored the report. “Even a modest rally in rates could lead to more refunding activity in 2024 versus 2023, which could lead to even stronger primary market growth.”

Tom Kozlik, HilltopSecurities head of public policy and municipal strategy, said he does not think interest rates will go down as fast as some participants expect and there will be some volatility, both up and down. Yet current interest rates are “generationally attractive” compared to what prevailed at the end of 2021, he said.

When The Bond Buyer asked professionals for their views on where credit quality was headed in the next five years, 40% said state and local governments would generally improve and 33% said they would generally decline. More granularly, 23% expect all issuer credit will improve, 18% said that only certain sectors are likely to improve. Over the next five years, 24% expect credit to decline overall and 9% expected declines in only certain sectors while 26% expect credit will be little changed.

When the analysts were asked about areas of credit weakness in the coming year, John Hallacy, president of John Hallacy Consulting LLC, and Kozlik agreed some higher education institutions, particularly smaller ones, will have trouble.

“A tough reimbursement climate and more procedures are affecting healthcare profitability,” Hallacy said.

“I think a slowdown in the economy will have some effects on state and local credits later in the year,” Mousseau said. “We also think that bigger cities with exposure to half empty office buildings will be facing some mounting pressure to reduce property taxes on these buildings and that will have a negative effect down the road in places like New York, Chicago, Houston, San Francisco, and other big cities.”

Kozlik said the end of federal COVID-19 aid to states and localities means investors need to carefully pick weaker credits from their portfolios and remove them.

Stiehl agreed, saying, “The market is going to re-focus on credit fundamentals in 2024 and beyond, particularly for issuers who received substantial aid from the federal government through the COVID relief bills. Issuers who used one-time federal grants to support recurring expenses are going to face tough budgeting decisions. … Investors who do deep credit analysis at the individual issuer level will be rewarded.”

In the survey, professionals had modest expectations for this year’s bond volume, with 42% expecting levels similar to 2023, 22% expecting less volume, and 18% expecting slightly more volume.

The analysts were generally mildly optimistic. Compared to the $380 billion issued in 2023, Hallacy predicted a $390 billion total in 2024, plus or minus $10 billion.

“Volume will probably creep ahead of last year — particularly in the latter part of the year because there will be a greater need to issue debt as the benefits of COVID funds go further in the rear-view mirror,” Mousseau said.

Kozlik said he has become more optimistic recently and now believes there will be $420 billion in issuance.

Stiehl noted, voters approved $110 billion of new issues last year, “which is high for a non-general election year and shows that public support for bond-funded infrastructure investments remains high.”

“We anticipate that will translate into more new-money supply and bring total volume above 2023 levels,” she said, adding she also believes refundings will rise.

In The Bond Buyer’s survey, the impact of this November’s federal elections was the third biggest concern for the coming year. Several market analysts also highlighted the importance of the federal election and policy.

“If the presidential candidates change tax policy or treat municipals differently, we could have upset in the markets,” Hallacy said.

Over the last 15 years the federal government has passed several laws and budgets with profound impacts on the market, according to Kozlik. The coming election could have a “very important” impact on munis for the next several years.

The federal debt to U.S. gross national product ratio is “very high,” he said, and the federal government might start to act on deficit reduction. In that context, he believes the tax-exemption could be at risk.

About two-thirds of survey respondents predict a recession for 2024. Kozlik said if that happens, the federal government may not be inclined to be so generous with state and local aid as was the case in the 2020 contraction.

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