The COVID-19 pandemic presented an international public health emergency with economic and social challenges no one could have predicted. It would be fair to describe these circumstances as unprecedented. However, in recent history, we have experienced other unprecedented events that presented significant market challenges. These have included: the financial crisis of 2007-08, the Great Recession, and more recent climate events. According to the National Interagency Fire Center, as of July 1, 2021, over 32,860 acres of land have burned in at least 337 wildland fires across the State. Furthermore, there have been 282 flash flood warnings issued throughout Colorado in 2021 versus the State’s 10-year annual average of just over 100 flash flood warnings.
Of course, these examples of market challenges are all unique in their own way. And while these events are often described as unprecedented, the municipal bond market has evolved over many decades to adapt to changing times, and incorporate protection into bond structures to support bond issuers and provide forms of security to bondholders. In recent years, as yields have progressively dipped and credit spreads tightened, certain issuers have shed many of the conventional security features and covenants in favor of cost savings or fewer restrictions. This trend is not unique to municipal bonds, and is also a trend in the corporate bond market, referred to as covenant-lite or “cov-lite” in the bond community.
Prioritizing Credit Quality
Despite this trend, we continue to prioritize credit quality and place value on bond covenants which, in many cases, are currently priced at substantially lower premiums than we have ever seen. The pandemic, and other economic and environmental conditions that are often described in the news as unprecedented, are why we continue to value these features. Through our actively managed investment approach, we continually monitor factors, such as credit quality, and seek to areas of opportunity consistent with the Fund’s investment objectives.
A Disciplined Approach to Risk Management
Although preparing for the unprecedented may seem daunting, this is precisely why we prepare a detailed analysis of each holding in the Fund’s portfolio, and then follow-up on that analysis with ongoing credit surveillance. These reports highlight the credit features and deficiencies that inform our investment decisions during volatile times. Security selection and sector exposure decisions are also determined as a result of our proprietary credit reports, which facilitate a more quantifiable determination of which risks are considered acceptable versus those without protection. This allows us to avoid the assumption of investment risk without the commensurate reward of additional yield. We meet quarterly with our credit committee, which provides guidance on timely credit topics and is prepared to convene on an ad hoc basis. We also maintain an internal credit monitor that notes developing economic and credit matters of concern and issuers, or entire sectors, which may periodically struggle. Nevertheless, despite currently tight credit spreads, we continue to prioritize credit quality as we anticipate the unprecedented.
A Look at How Bond Structures May Help Protect Investors
Aquila Tax-Free Fund of Colorado currently holds (as of 9/30/21) E-470 Public Highway Authority Senior Revenue Bonds, Series 2020, which were issued to refund E-470’s Series 2004A and 2010C Bonds. The 2020 Bonds are secured by a pledge of net toll revenues from the E-470 toll road. E-470 is one of the first U.S. tolling authorities to transition to an all-electronic tolling system. This sophisticated camera technology system reads sticker tag transponders and licen​se plates on passenger, rental and oversized vehicles at highway speeds. It includes 47 miles of a cashless, all-electric toll beltway, extending from Interstate 25 on the southern perimeter of the Denver metropolitan area to the western boundary of Denver International Airport, at the northern perimeter of the Denver metropolitan area.
COVID-19 caused dramatic reductions in vehicle traffic. E-470’s toll transactions decreased by 36% in 2020, which was the first decrease in 11 years.1 Passenger vehicle traffic was impacted by an emergency declaration issued by the Governor of Colorado on March 11, 2020, and a stay-at-home order issued on March 25, 2020 due to COVID-19. E-470 management was proactive in managing its operations, financial position, liquidity, and debt service coverage during the pandemic by making necessary budget cuts to its operating and capital budgets. No critical areas related to roadway safety and maintenance, or capital projects underway, were delayed or removed.
To protect investors, the 2020 bonds include a multi-layered security structure, which includes a covenant to maintain fees, tolls or other charges for the E-470 toll road to produce revenues not less than 1.3x debt service requirements, and dedicated funds set aside in a debt service reserve account. For the 2020 bonds, E-470 did not reduce its bond covenants. Instead, E-470 incorporated additional covenants. Debt service coverage on the bonds has ranged from 1.78x to 2.12x over the last five years, and was 1.85x for fiscal year 2020. E-470’s management places priority on both short and long-term financial health through a debt management plan designed “to preserve E-470’s bond rating, maximize financial results by reducing the cost of borrowing, and utilize financial tools to achieve flexibility, with a target of keeping the cost to E-470 customers as low as possible.” E-470 has in place an extensive investor relations website where it provides periodic, and recurring financial and traffic information. For comparison, most issuers provide an annual report and updates to certain required disclosures only once a year. A robust disclosure is vital in keeping investors informed on changing financial conditions.
E-470 also has financial policies to maintain unrestricted cash and investments of $200 million, or at least 800 days cash, on hand. For fiscal year 2020, the Authority had approximately 2,346 days cash on hand, providing a significant amount of liquidity. The Authority also complies with a financial policy to have an operating reserve fund balance that is 16.7% of budgeted operating expenses. The operating reserve fund position was $9.8 million, or 17.9% of operating expenses for fiscal year 2020.
Denver International Airport (“DIA”) is an economic engine for the state. Air travel was negatively impacted by travel restrictions due to the pandemic. As air travel is starting to take-off, and as international restrictions are lifted, the success of DIA is an all-around benefit to the state and E-470. Approximately 20% of toll transactions originates to and from the airport. DIA is approaching 2019 travel numbers, and in October 2021, was the third busiest airport in the world.2 Toll transactions have started to increased month over month from the lows of April 2020 as the state gradually opened up and as individuals became vaccinated. Toll transactions increased 27% as compared to the nine months ended September 30, 2020, and were down 18% as compared to the nine months ended September 30, 2019.1
1Airports Council International
2Colorado Department of Transportation
Mutual fund investing involves risk; loss of principal is possible. Investments in bonds may decline in value due to rising interest rates, a real or perceived decline in credit quality of the issuer, borrower, counterparty, or collateral, adverse tax or legislative changes, court decisions, market or economic conditions. Fund performance could be more volatile than that of funds with greater geographic diversification.
The Fund seeks to provide as high a level of income exempt from state and federal income tax as is consistent with capital preservation. For certain investors, some dividends may be subject to federal and state taxes, including the Alternative Minimum Tax. Consult a tax professional.
Information regarding holdings is subject to change and is not necessarily representative of the entire portfolio. It is for informational purposes only and not intended to represent a solicitation to buy or sell any particular security.
Before investing in the Fund, carefully read about and consider the investment objectives, risks, charges, expenses, and other information found in the Fund prospectus. The prospectus is available from your financial advisor, when you visit www.aquilafunds.com or call 800-437-1020.