What We're Watching For In The Second Half And Beyond

Ratings in the diverse local government sector include counties, cities, and school districts, GO, lease, and revenue-backed debt. Many of the challenges and opportunities we identified to start 2020 have shifted dramatically due to the COVID-19 induced sudden stop recession. Despite the variety of issuers and security types, there are common themes we are watching across all local governments during the second half of 2020:

• Potential state aid shortfalls or cost shifts, and how they are managed.
• The uneven health recovery and how it affects short- and long-term economic and revenue growth.
• Liquidity pressures brought on by revenue and expenditure mismatches, particularly for those with a weaker financial position and/or lower reserve levels.
• Expenditure pressures related to the pandemic.
• How issuers are projecting revenues, particularly those supported by sales and hospitality taxes.
• Long-term budgetary impact of social unrest and the probability of more across the U.S.

Rating Actions To Date

On April 1, 2020, S&P Global Ratings revised its sector outlook (since renamed sector view) for all of its U.S. public finance sectors to negative, which includes over 10,000 local government credits. Given the historic stability in the sector, revising the sector outlook was an unprecedented step. Four months later, we continue to see signs of credit weakening across the sector, and expect more to come.

Since the start of the pandemic, there have been 616 rating actions related to COVID-19 on local government issues, primarily outlook changes (see "COVID-19 Activity In U.S. public Finance"). The biggest changes have come for debt backed by convention center and/or hospitability taxes; that group also includes some multi-notch rating changes (for more, see "Changing Landscape Threatens Credit Quality Of U.S. Convention Centers, Arenas, And Stadiums," published June 27, 2020, on RatingsDirect). We also revised most of our positive outlooks to stable reflecting a very different landscape for rating upgrades over the near to medium term.

Priority Lien Revenues Are The Most Exposed

We have performed portfolio reviews across local governments and these efforts confirm that priority lien ratings are the most exposed to revenue declines related to social distancing, specifically convention centers and hospitality taxes like hotel, food and beverage, etc. Hospitality taxes across the U.S. performed unevenly based on the extent of local closures, re-openings, re-closures, etc., but all experienced decline considering the large-crowd nature of their operations. Given the vulnerabilities seen in these two sectors, we are keeping a very close eye on revenue flows and credit pressure, particularly for signs of liquidity issues.

A sustained period of lower hospitality tax collections can lead to sharp drops in debt service coverage for bonds secured by those taxes, and this has been a particular pressure for convention center and sports facility issues. Significant deterioration in hospitality related revenues has led to imbalanced budgets, reduction in debt service coverage, and in many cases drastically reduced liquidity available to pay debt service. Such a notable shift in a very short period has led to deterioration in credit quality for many issuers and resulted in 16 downgrades since March.

Although not as hard-hit as hospitality taxes, sales tax collections have also been uneven. Like hospitality taxes, we expect the impact to sales taxes will mirror reopening patterns, but given ongoing e-commerce the impact is not as pronounced as tourism and business-travel based taxes. "As The North American Retail And Restaurant Sector Braces For Another Wave Of Downward Rating Actions, A Few Subsectors See Signs Of Hope," published July 17, 2020, describes a struggling situation for most retail and restaurants, indicating tax collections associated with those purchases are not expected to rebound quickly. This creates additional uncertainty for debt service coverage levels in a sector where we've already seen some significant revenue deterioration and pressured liquidity.

General Obligation And Lease Secured Debt Won't Go Unscathed

In general, local governments started 2020 with reserves that had been growing, and we expect this will provide some flexibility to offset revenue declines. However, reserves will likely not be sufficient to offset a prolonged recession and slow recovery.

Since local governments, school districts, and charter schools can be heavily dependent on state shared revenues for general operations, the overall strength of the states is critically important, so we are watching state budget revisions and any projected cuts closely to see which states may start to see pressure first. This is of particular importance for school districts and charter schools that generally carry lower reserves, are more likely to experience state aid cuts when state revenues fall short, and are also being hit with COVID-19 school preparation costs. For more on our view of state credit quality, see "U.S. States Mid-Year Sector View: States Will Continue To Be Tested In Unprecedented Ways," July 13, 2020.

Overall, we expect local property tax bases to remain stable, which should help insulate the governments that rely on them for revenue generation. We expect that there could be longer term implications for the commercial and residential real estate market related to the recession. However, despite some expected stability in property tax revenues, local governments that rely on non-property tax sources will likely experience greater budget volatility. Regardless of revenue mix, we feel that governments with low reserves and liquidity have less flexibility and will be most exposed from a credit standpoint. We will continue to analyze shifts in the property tax base as well as taxes generated by business and consumer demand and incorporate those factors into our analyses.

Federal Support Is Critical To Long-Term Credit Quality

Federal funding for COVID-19 related expenses has helped offset unanticipated expenditure pressures for some local governments. However, without a replacement for revenues lost during shutdowns, while the expenditure reimbursement dollars can be helpful for short-term liquidity, they are less so for maintaining structural balance. As the virus and economic landscapes change, support from the federal government will remain a critical part of the overall health of governments in this challenging chapter of local government finance.

Without support for state and local governments from the federal government as needed, premature austerity--where the federal government abandons support for locals sooner than what may be needed to maintain financial stability--would likely lead to credit deterioration for many issuers. The latest stimulus plan being negotiated in Washington seems likely to include support for local governments, including schools. However, should the negotiations take a different turn and not include money for locals, the potential for downgrades in the current recession would increase markedly.

How A Slower Economic Recovery Influences Credit Quality

With reemergence of virus transmission rates nationally, economic uncertainty is elevated and it appears that even the slow recovery S&P Global Economics forecasted may be losing steam. (For more from our economists, see "U.S. Economic Update: A Recovery At Risk As COVID-19 Surges," published July 22, and "Economic Research: The U.S. Faces A Longer And Slower Climb From The Bottom," June 25.) Considering the belief that the U.S. is facing a long, slow recovery, and given our expectation that the health recovery will be uneven, we believe some states will lag behind others in the recovery. How this affects revenues for local governments, schools, and charter schools is also likely to vary widely and will create differentiation in credit quality.

In the meantime, since many taxes are disbursed one to two months after collections--and given our expectation for no immediate impact to property taxes--local governments have had the opportunity to plan for the revenue shortfalls they know are coming. Those that address potential budget imbalances pro-actively will be best-positioned to weather economic volatility, in our view. However, considering projections for slow economic growth through 2021, we expect local governments will be facing an uphill battle for some time.