After 18 months of pandemic, we believe the municipal market has fully recovered. Though the market’s reopening and reflation have been dominant themes to date, federal policy changes, particularly regarding taxation, and infrastructure spending will now more likely command market attention—and advance normalization.

The Fed and U.S. Treasury have continued to provide support, with monetary stimulus and low rates boosting economic activity and benefiting municipals. The vital nature of municipal projects also has been a stabilizing factor.

Macro trends unquestionably are positive. But fundamental analysis will remain vital in evaluating specific credits. Here is our current take on several key situations, from California to Puerto Rico, and two key sectors:  higher education and senior living.

California Water Utilities: Managing Drought
Though drought now grips much of California, wide-scale water-system defaults are not expected, as these systems provide an essential, monopoly service. However, downgrades could occur to systems not prepared for significant drought impacts.

Specific effects depend on system location, mix of water supplies, storage options, and size and sophistication in managing revenue disruptions from reduced consumption.

California law requires large water suppliers to plan responses to both a multiyear drought and a single year cutback of up to 50% in supplies. Some systems have even turned to emerging technologies such as desalination to offset shortages.

Clearly, the longer severe drought persists, the greater the potential for fiscal stress. But water utilities have entered the current crisis on strong fiscal footing with solid debt service coverage and liquidity—providing critical financial flexibility against unforeseen events and potential rate increases.

Illinois/Chicago General Obligation Debt: Fiscal Stimulus Provides Boost
We cannot overstate the American Rescue Plan’s importance for municipal credit quality. With Federal funds allocated to municipalities, schools, transportation facilities and other recipients over the next 18 months to two years, the ARP and the economy’s reopening and V-shaped revenue recovery have created strong catalysts for upgrades.

Lower-rated general obligation (GO) debt is already reaping benefits. Illinois has been the muni bond market’s highest performing area year-to-date. Both Moody’s and S&P have upgraded the state’s GO credit, moving the state further away from high yield. This has contributed to substantial credit spread narrowing for state GOs, and the city of Chicago, the Met Pier & Exposition Center, the Board of Education and other lower-rated names.

Puerto Rico: Fiscal Surplus Anticipated
Recent Covid-relief funding for Puerto Rico follows $83.5 billion in federal disaster relief related to the 2017 hurricanes, most of it still being deployed. Unprecedented federal aid and the recent uptick in economic activity have benefited government revenues.

The 2021 fiscal plan projects a $6.7 billion surplus from 2022 to 2026. But longer term, Puerto Rico’s Financial Management and Oversight board still projects a deficit absent structural reforms.

Momentum toward exiting the Title III bankruptcy process continues, but how to pass some remaining hurdles is not entirely clear. Importantly, the oversight board has reached consensual agreements with overwhelming majorities of creditors holding bonds of the remaining bond indentures to be restructured: the General Obligation, the Electric Power Authority (PREPA) and the Highway Authority. While the proposed restructuring agreements of these three entities have substantial support from most of the key constituencies, execution will involve some complexities; in some cases, the Puerto Rican Government will need to pass new legislation. 

As the board and government move through debt restructuring over the balance of the year, investors should brace for some uncertainty, with inevitable political posturing likely generating negative headlines and possible delays. But we do see substantial momentum building behind these three agreements. Ultimately, successful emergence from Title III for the remaining credits would provide a positive psychological and technical boost for the high yield municipal market overall. 

Higher Education: Small Private Colleges, Universities Vulnerable
The higher ed sector has shown more resiliency and greater flexibility than expected at the pandemic’s outset.  Federal stimulus helped, with institutions receiving nearly $80 billion.

However, small private colleges and universities in demographically challenged regions face more risk of  severe ratings pressure and credit concerns than larger institutions with robust balance sheets and student demand. Lacking strong market differentiation and with perceived tuition rates higher than local public universities, small institutions have experienced relatively steeper enrollment losses over the past year.

Federal stimulus will help many smaller institutions ride out the next one to three years. However, given market dynamics accelerated by the pandemic, viability will demand mergers, partnerships, program rationalization, and revenue diversification.

Senior Living: Due Diligence Critical
Covid-19 raised significant questions about high-density communal living arrangements for seniors. The pandemic pushed occupancies down sector-wide, especially in assisted living and skilled nursing.

The sector has been slow to rebound and governmental support has been minimal. Balance sheets and liquidity are suffering. In some cases, the pandemic’s actuarial impact will not be obvious for years, and underfunded future health-care expenses will generate future stress.

The sector still has few barriers to entry, but many speculative, highly levered, and developer-driven deals face competition after opening. And the sector’s bondholders are finding that regulators, keen on defending resident refund rights, are making it harder for continuing care retirement communities to stay solvent.

Demographics remain positive. But success requires making informed choices about which deals will rebound; are not overly levered or in overly competitive markets, and have adequate resources to meet future actuarial needs.

John Miller is head of municipals at Nuveen.