Federal Policies Help Spur Municipal Bond Market, but Headwinds Remain

Municipal bond analysts are generally optimistic about the stability of state and local government finances in 2022, largely thanks to the influx of federal funding over the past two years. But lingering issues including the rapid spread of the omicron variant, accelerating inflation and supply chain bottlenecks still pose economic and fiscal risks to governments in the short term.

Bond issuance last year totaled $476 billion, a slight decrease over 2020, which saw unusually heightened refinancing activity as governments tapped the market for cash to weather the onslaught of the pandemic. Ratings analysts expect government issuance this year to be comparable to 2021’s total and predict that any year-over-year increase in activity is likely to be driven by new debt.

The $350 billion in fiscal recovery funds to governments from the American Rescue Plan has played a big role in stabilizing the revenue picture by providing money to offset decreases in revenue. More recently, the passage of the Infrastructure Investment and Jobs Act represents $550 billion in new, one-time funding that can either supplement state and local infrastructure project costs or pay for them outright.

“Massive federal aid will help states make up for spending cuts early in the pandemic and further address emerging social and environmental risks,” noted Moody’s Investors Service in its 2022 public finance outlook report, adding that “the new federal infrastructure law will help [local governments] ease financial challenges.”

But some analysts caution that the new money available to governments could mask longer-term risks. The Federal Reserve’s anticipated rate hike this year isn’t likely to significantly raise the cost of borrowing, but Municipal Market Analytics Managing Director Lisa Washburn pointed out that inflation is likely to increase materials and labor costs—thereby raising the amount of debt governments have to sell to finance projects.

That makes debt “less efficient” and the end result could be a “slow bleed” of credit quality in state and local governments, Washburn said. But, she added: “You won’t see that for a while because of all the cash coming from the feds.” 

Growth Is Slowing

State and local government tax revenue jumped last fiscal year, largely thanks to better-than-expected income tax returns and sales tax revenue growth, and that pace continued into late 2021. In November, the Urban Institute’s Lucy Dadayan reported that total state tax revenue from April to November 2021 was 20% higher than it was during the same six month period in 2019 before the pandemic hit. Already, the national average income- and sales-tax growth is outpacing the pre-Covid trend, according to Breckenridge Capital Advisors.

However, many believe that labor and supply chain challenges could slow the pace of economic growth while inflation stands to erode household purchasing power. Credit ratings agencies and municipal analysts have all cited these factors as evolving issues to watch this year. “Labor shortages are beginning to trigger wage pressure for government employees, with the potential to erode expenditure flexibility for issuers,” Fitch Ratings said in a report recently.

Some are also watching the spread of the omicron variant of the coronavirus with a wary eye. Tom Kozlik, HilltopSecurities’ head of municipal research and analytics, said he initially predicted that municipal market bond issuance would total $495 billion this year. But now that economists have begun revising economic growth downward, he’s questioning how that may affect the bond market.

“The [virus] is going to be impacting economic activity … at a pace that I didn't expect in December,” he said. “It means the ‘Golden Age of Public Finance’ I’ve been talking about is definitely under threat.”

In particular, the lingering effects of the pandemic and increased expenses are keeping the financial pressure on public health-care entities, making it the only public finance sector in 2022 with a negative ratings outlook in the Moody’s public finance report. The ratings agency noted that “staffing shortages will increase labor costs and be the main driver of higher expenses,” while “chain disruptions, increased drug costs, higher inflation and increased investment in cybersecurity” will also push up costs.

A More Stable Market 

Overall, state and local governments are in a far better position as they recover from the Covid-induced recession than they were after the Great Recession and that’s good news for the bond market. Federal aid to governments during the last recession dried up long before budgets recovered, resulting in state and local spending cuts that ultimately slowed the economic recovery.

During this era of austerity, state and local government debt contracted from more than $3.2 trillion in 2012 to less than $3.1 trillion in 2019, according to data from the Federal Reserve. While this low supply and high demand for bonds was advantageous for governments from a pricing standpoint, it also meant that governments were putting off capital projects. One report estimates that the country has more than $1 trillion in deferred infrastructure maintenance, a liability that mainly state and local governments are responsible for.

While the federal aid this time around was significant, it’s not enough on its own to put a dent in the deferred investment—and that’s not taking into account new investments such as electric vehicle fleets and climate-friendly projects. The key, said Fitch, is how governments divvy up the aid between repairing and replacing critical infrastructure, and whether governments’ own additional investment results in sustainable economic growth.