Entering 2020, municipal credit fundamentals remain broadly stable amid lingering long-term credit issues. Upcoming federal elections are unlikely to have a meaningful impact on the municipal market, absent unexpected House or Senate results. In contrast, ballot initiatives in Illinois and California could prove relevant to each state’s credit quality. Concerns over federal austerity and attendant risks to the municipal market are likely on hold for the foreseeable future. Credit spreads and absolute yields are likely to remain low as new money issuance increases but is offset by strong demand for municipal debt. Given the market setting, we continue to favor a high-grade bias and the addition of more A-rated names only when spreads warrant.
CREDIT FUNDAMENTALS REMAIN BROADLY STABLE
Municipal credit quality entering 2020 is largely consistent with that of 2018 and 2019. Top-line indicators of credit stability suggest a benign credit environment, but a variety of long-term structural risks remain that warrant close monitoring. Market strengths include:
A still-healthy U.S. economy. Entering the new year, the unemployment rate was 3.5 percent and the labor force was still growing.1 The expansion is broadening geographically. In 2Q19, all 50 states experienced positive real growth in gross state product (GSP) for only the third time since 2006.2 Ongoing trade tensions have dampened growth in some manufacturing- and agriculture-based states but, with few exceptions, trade issues have yet to meaningfully impact credit quality.
State reserves are up. The 50-state median for reserves will reach 8 percent of expenditures in FY 20, a historic high (Figure 1). Importantly, many of the largest states – which issue the most debt – are reporting solid financial performance; California, Texas and Florida each expect surpluses this year.3
Tax collections are up. Recent federal tax law changes continue to benefit state and local issuers. Personal and corporate income tax receipts were up 5 percent and 16 percent, respectively, through 3Q19. Sales tax revenues were up 10 percent over the same period. Personal and corporate income tax growth reflects, in part, federal reforms that took effect in 2018 per the 2017 Tax Cuts and Jobs Act (TCJA). Filers who sought extensions for the 2018 tax year paid tax in October 2019. Growth in sales tax collections partly reflects the Supreme Court’s 2018 South Dakota v. Wayfair decision. That ruling allowed states to impose tax collection responsibilities on remote sellers.4
Strong real estate market. Rising home prices are a credit positive for local debt issuers, which typically rely on property taxes to fund operations and debt payments.5 Home prices are up in each of the nation’s largest 100 metro areas as compared to five years ago (Figure 2). The relatively healthy real estate market is one reason that 76 percent of city finance officers report they are “better able to meet fiscal needs” heading into 2020.6
Debt levels. State and local debt now comprises 13.8 percent of gross domestic product (GDP), down from almost 20 percent in 2010 (Figure 3). Typically, lower debt levels translate into better credit quality.
Low default rates. The municipal default rate increased in 2019, but it remains low compared to historic levels (Figure 4). The uptick in defaults in 2019 largely reflects weaker covenants and underwriting standards, mostly in the nonrated space and in speculative sectors; for example, senior housing and land districts.7
Favorable ratings trends. Upgrades have exceeded downgrades at both Moody’s Investors Service and Standard & Poor’s for seven consecutive quarters. All major public finance sectors have received a stable or positive outlook from Moody’s for 2020.8
Fiscally sound utilities. Water, sewer and electric utilities exhibit solid liquidity and coverage numbers entering 2020 (Figure 5). Strong utility fundamentals should help most utilities manage growing environmental, social and governance (ESG) risks over the near term.9 Looming ESG risks for utilities include water scarcity and quality challenges (for water-sewer systems) and more-stringent renewable energy standards (for electric utilities), among others.
KEY RISKS REMAIN IN PLACE
Despite solid top-line fundamentals, a variety of long-term risks remain in place, many of which we have addressed in prior years.10 These include:
Burdensome pension and OPEB liabilities. Pension and retiree health care costs (also known as “OPEBs” or “other post-employment benefits”) remain a credit albatross for some state and local governments. Strong stock market performance since January 2017 has helped stabilize the nation’s aggregate unfunded pension liability.11 However, elevated pension and OPEB liabilities continue to contribute to credit weakness in several states (Figure 6), and most large cities still annually underfund their pension systems.12
Elevated asset prices. Today’s muni market remains exposed to asset-price risk to an unprecedented degree. U.S. net worth, which is mostly composed of real estate holdings and stock, is 4.7 times GDP, well above its 67-year average of 3.9 times.13 As we explained last year, asset-price risks can threaten an issuer’s tax base, pension fund and capital gains tax receipts.14
Ongoing deferred maintenance. State and local capital spending was up 5 percent on a year-over-year basis through October 2019.15 However, the uptick in spending falls well short of amounts needed to maintain the nation’s infrastructure assets. State and local infrastructure continues to age across most public finance sectors (Figure 7).16
Elevated “willingness risk.” One reason for the nation’s decaying infrastructure is taxpayer unwillingness to pay for improvements. In past years, we have highlighted “willingness risk” in the context of issuer refusal to honor bond covenants. But in 2019, there were several notable examples of residents balking at higher fees for the use of toll roads. This is another form of credit-relevant “unwillingness.” In Connecticut, residents pushed back at the governor’s proposal to impose tolls on the state’s highways.17 In Florida, lawmakers dissolved the Miami-Dade County Expressway Authority to limit toll increases.18 In New York, state lawmakers enacted a congestion pricing scheme for lower Manhattan, but it’s unclear whether the plan will be implemented as designed.19
More acute climate risks. Climate-related risks are increasingly relevant to credit assessments. In 2019, San Francisco International Airport announced a $587 million bond issue to upgrade its seawall;20 New York City’s mayor proposed a $500 million resiliency plan to protect lower Manhattan;21 and “managed retreat” became a reality in the Florida Keys, where authorities plan to abandon road improvements in certain flood-prone areas.22 We expect that more municipal issuers will disclose climate-related risks in the coming years. As disclosure improves, investors are likely to place a premium on climate risk, which may show up in bond prices.
More single ratings. Municipal bonds are increasingly rated by only one rating agency. In 2010, 72 percent of market par carried a rating from both Moody’s Investors Service and Standard & Poor’s. Today, only 50 percent of the market is dual-rated (Figure 8). The growing incidence of single-rated bonds is a negative for market liquidity, especially given rating agencies’ recent penchant for changing credit-rating methodologies and applying multiple notch adjustments.23
Nonessential borrowing is up. Industrial development bonds (IDBs) now comprise 15 percent of municipal market debt, up from 7 percent in 2004 (Figure 9). Given that IDBs typically finance less-essential public projects, the uptick in IDB penetration is less than ideal.24 Nonessential municipal debt tends to encounter credit troubles at a higher rate than bonds issued for essential services like schools, roads and utilities.
Long-term concerns for the hospital sector. Nonprofit hospital issuers continue to face a variety of long-term trends and regulatory risks that threaten credit stability. This includes (a) population-aging, which tends to increase per-patient health costs; (b) the proliferation of high- deductible health plans, which are associated with higher bad-debt expense (Figure 10); and (c) an increase in hospital mergers, a phenomenon that sometimes threatens credit quality.25
Ongoing challenges in Puerto Rico. Puerto Rico’s economy has stabilized entering 2020, and the Commonwealth should benefit from a recent federal budget agreement that extends the island’s extraordinary Medicaid funding for two years.26 However, Puerto Rico’s long-term credit profile remains highly speculative and its market access uncertain. In 2019, the Commonwealth managed to refinance its sales tax-backed Cofina bonds. If Puerto Rico can reach more deals with creditors in 2020, any new restructured bonds would likely carry speculative-grade ratings and enter the high yield index. That could make the high yield market marginally more volatile or risky. The Commonwealth has proposed recoveries for general obligation (GO) bondholders in the 35 percent-to-64 percent range, but no agreement has been completed.27
ELECTION YEAR CONSIDERATIONS
2020 federal elections. The federal elections are unlikely to meaningfully affect the municipal market, in our view. We expect the partisan makeup of the House and Senate to remain unchanged post-2020.28 Such an outcome should limit policy changes that could affect the municipal market, regardless of which party controls the presidency.
Transformational policy is most plausible in the least-likely election outcomes. For example, if Democrats win the presidency and retake the U.S. Senate, a large-scale infrastructure bill, reintroduction of the Build America Bonds program, and/or higher marginal income tax rates become a possibility. Issuance would likely rise in such a scenario, or ratios might decline. If President Donald Trump is re-elected and Republicans retake the House, Congress might consider curtailing the tax exemption, lowering marginal rates or introducing an infrastructure plan that involves more private activity bonds or privatization.
Figure 11 summarizes the most likely results of the federal elections, in our view. Volatility could increase in the latter half of 2020 if one of the unexpected outcomes becomes more plausible. For a more complete discussion of the federal elections, see our piece 2020 Election Quick Take.
Ballot initiatives in key states. In addition to federal elections, ballot initiatives in California and Illinois could impact credit quality.
In California, voters will decide whether to amend Proposition 13, the state constitutional provision that requires all real estate to be assessed at its purchase price. The proposed amendment would change the law to permit market value assessments for commercial and industrial property. The initiative would generate $6 billion to $12 billion in new revenue for local schools and municipal governments.29 Over time, it also likely would shift the property tax burden to businesses and away from residents. Passage of the amendment would likely be a credit positive for many California local GO bonds. It could, however, increase the cost of doing business in California, which already is high relative to other states.
In Illinois, voters will decide whether to amend the state constitution to permit a graduated income tax. In conjunction with a law enacted in June 2019, passage of the amendment would raise Illinois’ top marginal income tax rate from 4.95 percent to 7.99 percent.30 The market broadly expects the amendment to pass, which is necessary to avoid large budget cuts.31 If it passes, Illinois will migrate to “specialty state” status, as its top income tax rate will be among the highest in the nation. Illinois’ credit quality also likely would stabilize in the near term. But if the amendment fails, Illinois credit spreads could widen further.
Federal austerity on hold. In past Outlooks, we have noted that the federal government’s weakened fiscal condition makes it a less reliable partner in delivering state and local services and ensuring bond market stability during a recession.32 We remain concerned about the federal government’s fiscal imbalance over the long term. However, there is currently limited political support for federal austerity, and the most plausible election outcomes are unlikely to change this dynamic. Public worry over the deficit is at its lowest point since 2011.33 Interest rates are low, and Congress and the president added $2.2 trillion to the national debt in 2019.34 Loose fiscal policy is likely to characterize the federal ledger for the time being.
MARKET TECHNICALS ARE LIKELY TO KEEP CREDIT SPREADS LOW
Market demand and supply trends are pressuring yields and credit spreads lower in concert with the stable credit environment. If our base case for the election plays out, there should be limited election-related risks.
Demand. Demand for municipal securities remained strong in 2019. Notably, the municipal mutual fund space experienced 52 consecutive weeks of inflows, totaling nearly $94 billion for the year. Both figures were records.35 Inflows were driven, in part, by declining interest rates (Figure 12), but demand for municipals is likely to remain reasonably strong. Demand for tax-exempt bonds benefits from (a) a growing number of older investors, who tend to be attracted the asset class; (b) less competition from other tax-advantaged asset classes post TCJA; and (3) the likelihood that income tax rates will rise at some point (the federal deficit is expected to grow and federal revenue is historically low, at 16.4 percent of GDP).36
Taxable municipals are also in demand.37 Notably, foreign participation in the muni market continues to grow. Foreign holders represent almost 3 percent of the market, up from just over 1 percent at the beginning of the 2010s.38 Foreign buyers tend to enter the market when taxable yields widen, providing a reliable support for the taxable muni market in recent years (Figure 13).
Supply. Tax-exempt supply remains tepid. Tax-exempt issuance was 13 percent in 2019.39 However, more municipal bonds are maturing than are being sold. Net issuance remains negative. There are two main reasons for the declining size of the municipal market. First, the aforementioned TCJA barred tax-exempt advance refundings. Beginning on January 1, 2018, issuers lacked an ability to refinance outstanding bond debt prior to its call date. Second, voters and policymakers remain debt averse in many areas of the country.40 As Figure 14 illustrates, the market continues to shrink. We expect these patterns to hold steady in 2020.
By contrast, taxable supply is likely to increase in 2020. In the latter half of 2019, interest rates declined far enough to make taxable advance refundings economical for many issuers, and taxable issuance jumped.41 Through November 2019, taxable issuance comprised 16 percent of the market, the highest level since the last year of the Build America Bonds program (2010). This trend is expected to continue, as tax-exempt advance refundings remain prohibited per the TCJA and Treasury rates remain low. Taxable advance refundings appear to make financial sense when the 10-year Treasury rate falls below 2 percent (Figure 15).
SPREADS AND YIELDS REMAIN LOW
We believe the combination of stable credit fundamentals, limited election-related risks, strong demand and limited supply (at least in the tax-exempt space) is likely to keep spreads and absolute yields rangebound in 2020 (Figure 16). Given that spreads and yields are near their post-recession lows, we see limited value in taking additional credit risk. Still, we expect few changes to the environment over the next 12 months. For that reason, we favor adding – or at least maintaining – A-rated exposure in accounts, when market conditions warrant.
 Bureau of Labor Statistics, December 5, 2019.
 Bureau of Economic Analysis Regional Data, November 2019.
 Keely Webster, “California LAO forecasts $7 billion surplus for fiscal year,” The Bond Buyer, November 27, 2019. Texas Comptroller’s Cash Flow report, September 2019: https://floridapolitics.com/archives/313516-sunburn-the-morning-read-of-whats-hot-in-florida-politics-12-16-19. Note that New York State expects a deficit despite 13% growth in tax revenue: New York State Department of Taxation and Finance, September 2019 monthly tax collection report.
 Per the U.S. Census Bureau, advance retail sales growth was 3.2% on a year-over-year basis through October 2019.
 2017 Census of Governments.
 Seventy-six percent of finance directors say they are “better able to meet their fiscal needs” per the National League of Cities annual “Fiscal Conditions” survey (2019). Also, per Moody’s Investors Service, “strong reserves” and “financial flexibility” position most large U.S. cities to weather a recession,” Moody’s Investor Service, December 10, 2019.
 Municipal Market Advisors, Default Trends, December 6, 2019.
 Moody’s Investors Service 2020 Public Finance Outlooks, December 13, 2019.
 Moody’s Investors’ Service 2020 Water and Sewer Utilities outlook, December 4, 2019, and Moody’s Investors’ Service 2020 Public Power Utilities outlook, December 5, 2019. Note that for utilities, community choice aggregators (CCAs) may also become a growing risk to some California systems. CCAs enable localities to buy power (often renewable power) from a third party other than a utility, which can erode utilities’ margins.
 https://www.breckinridge.com/insights/details/2019-municipal-bond-credit-outlook/ and Breckinridge 2018 Municipal Bond Credit Outlook.
 Federal Reserve Flow of Funds and Bureau of Economic data show that the nationwide unfunded pension liability is roughly 20 percent of U.S. GDP, down from over 22 percent in 1Q16. See Table Z. 120b. The Federal Reserve applies a risk-free rate to calculate the aggregate unfunded liability for the largest state and local pension plans.
 “Pensions remain the dominant liability for most of the largest local governments,” Moody’s Investors Service, December 19, 2019.
 Breckinridge analysis of Federal Reserve and Bureau of Economic data.
 For example, a downturn in the housing or stock market would likely trigger increases in pension contributions and a decline in local property tax bases, albeit on a lag. It would cause a drop in personal income tax collections, especially in states with high, and progressive, income tax rates. States with a high proportion of capital gains income would suffer disproportionately, as well. In our view, downgrades would likely follow a stock or real estate market correction notwithstanding improvements to state and local government reserves.
 Breckinridge analysis of U.S. Census data based on the 12-month rolling average of state and local capital spending.
 Governments often defer infrastructure maintenance to preserve cash but, eventually, poorly maintained roads, bridges and mass transit systems, among other infrastructure, accrue to the financial and economic detriment of communities. At some point, issuers need to borrow, raise fees or taxes, or spend down reserves to fund necessary improvements. Each of these options can erode credit quality. Breckinridge Perspective – Infrastructure Accounting: A Blind Spot Facing Investors.
 Mark Paznoikas and Keith M. Phaneuf, “Top Democrats unite behind Lamont on truck tolls,” CTMirror.org, November 26, 2019.
 Shelly Sigo, “Florida judge strikes down bill abolishing Miami-Dade toll road agency,” The Bond Buyer, August 12, 2019. Note that the law was struck down as unconstitutional by a state court in August 2019. However, the state has appealed the ruling. As a result, the expressway agency currently lacks a board of directors.
 Benjamin Kaba, “The fight over exemptions will determine the fate of NYC’s congestion pricing,” Curbed New York, April 8, 2019.
 Paul Rogers, “SFO plans to surround airport with 10-mile wall to protect against rising bay waters,” The Mercury News, October 10, 2019.
 Office of the Mayor of New York City, March 14, 2019. https://www1.nyc.gov/office-of-the-mayor/news/140-19/mayor-de-blasio-resiliency-plan-protect-lower-manhattan-climate-change#/0.
 Christopher Flavell and Patricia Mazzei, “Florida Keys Deliver a Hard Message: As Seas Rise, Some Places Can’t Be Saved,” The New York Times, December 4, 2019.
 Bonds can now suffer multi-notch downgrades from one agency, without the support of a second rating. Note that through October 2019, Standard & Poor’s had downgraded 507 dedicated tax bonds based on its new priority lien criteria, adopted in late 2018. In November 2019, the agency announced changes to its housing bond methodology that would negatively impact 30 percent of that sector’s ratings. “List of Rating Actions Due to Priority-Lien Revenue Debt Criteria,” Standard & Poor’s, November 15, 2019; “Methodology for Rating U.S. Public Finance Rental Housing Bonds,” Standard & Poor’s, November 4, 2019.
 Importantly, there has been no rapid acceleration in issuance of IDB debt. Rather, IDB’s larger proportionate share of the market mostly reflects the shrinking supply of essential service debt.
 For the time being, hospital credit fundamentals are stable. Margins, coverage and debt levels have changed little across the sector in the past 12 months. Conclusions based on Breckinridge analysis of Merritt Research Services data, December 2019.
 Rachana Pradhan, “Trump slashed Puerto Rico’s Medicaid money as part of budget deal,” Politico, December 17, 2019.
 Andrew Coen, “Puerto Rico oversight board carves path to exit bankruptcy,” The Bond Buyer, September 27, 2019.
 Breckinridge 2020 Election Quick Take: https://www.breckinridge.com/insights/details/2020-election-quick-take/.
 California Legislative Analyst’s Office (LAO): https://lao.ca.gov/BallotAnalysis/Initiative/2019-008.
 Illinois Senate Bill 687 of 2019.
 Gallup polls conducted each March from 2011-2019. Available at: https://news.gallup.com/poll/147626/federal-budget-deficit.aspx.
 Committee for a Responsible Federal Budget: http://www.crfb.org/blogs/policymakers-added-22-trillion-debt-2019
 J.P. Morgan, for the period ending 12/31/19.
 For more on the aging of the U.S. population and the municipal market, see: https://www.breckinridge.com/insights/details/exploring-the-relationship-between-an-aging-population-and-state-and-local-credit-risk/. Older investors, many of whom live on fixed incomes, are broadly attracted to municipals for their safety, reliability and production of tax-free interest. With regard to the TCJA, it reduced deductions and exemptions and expanded the individual tax base by a net $400 billion (per Breckinridge analysis of Joint Committee on Tax report: https://www.jct.gov/publications.html?func=startdown&id=5053). With regard to higher tax rates, increased revenue could take a variety of forms, including a curtailment of the tax exemption, a carbon tax, a value-added tax or higher estate tax rates. However, we believe a higher personal income tax rate is likely to be at least part of the solution.
 Despite the large increase in taxable supply during the last quarter of 2019, AAA taxable spreads fell from 85 basis points on 10/1/19 to 75 basis points on 12/31/19. The lack of meaningful spread movement suggests that demand for taxable munis remains relatively strong, in our view. Data is per Thomson Reuters, TM3.
 Federal Reserve Flow of Funds.
 “Bond Sales Year-to-Date,” The Bond Buyer.
 Debt aversion manifests itself for different reasons in different areas of the country. In some places, debt aversion reflects weak demographic prospects (e.g. Maine or West Virginia). In others, it reflects policy choices. For example, in Florida, former Gov. (now Sen.) Rick Scott made decreasing state debt a key priority. So, although Florida’s economy is strong, its direct debt load has declined from $22 billion in 2010 to $17 billion today (Breckinridge analysis of Merritt Research Services data). In Connecticut, the debt load is no longer growing since the state implemented new budget rules in October 2017.
 The Tax Cuts and Jobs Act of 2017 prohibited tax-exempt advance refunding, but nothing bars municipal issuers from issuing taxable debt to refinance tax-exempt obligations.
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