More Posts
Looking for more information on fixed income trends and market opportunities?
Navigating Divergent Trajectories—Event Risk in Higher Education Taxable Municipals
- By Garrett Falzone, Principal, Head of Municipal Bond Research
- November 19, 2020
Since the COVID-19 virus prompted precipitous, large-scale changes to traditional classroom settings, headlines about the challenges facing higher education have become all too common. Indeed, the exogenous shock spurred by remote instruction, rising virus case counts, and reduced revenue streams has increased risks within the sector and accelerated the divergence in its underlying trends. At the same time, we believe this shift, in tandem with the surge in higher education taxable municipal issuance, particularly from institutions that are best positioned to survive this challenging environment, has also created opportunities for active credit investors.
Although recessions generally have a greater impact on households with only high-school educations, they also tend to prompt questions regarding the value of tuition investments. As a result, higher education institutions have experienced a general decrease in pricing power since the 2008-2009 financial crisis, leading to a reduced slope in the tuition inflation curve over the past decade (Figure 1).
Figure 1: Higher-Education Pricing Dynamics Have Lost Some Momentum Since 2008-2009
This shift in pricing dynamics over the last decade has created a challenging fundamental backdrop, particularly for institutions that don’t have an appreciable value proposition. It’s also not unreasonable to expect this increased fundamental pressure to accelerate our expectations of consolidation within the higher education sector. Taken together, we believe this environment will likely create far less winners than losers over time.
Grading the Winners and Losers
We characterize the sector “winners” as institutions that continue to attract students while exercising pricing power (e.g. not continually attracting enrollment through tuition discounting) which drives improved credit quality. Specifically, we place “winners” in three categories:
- Category 1: high demand, highly-selective schools with large endowments and significant revenue diversity;
- Category 2: flagship public universities with diverse revenue streams that offer students relatively affordable education from a recognizable name;
- Category 3: leading specialized schools that have high demand and pricing power derived from their elite recognition within its niche sector.
In the taxable municipal market, institutions in the first two categories represent attractive credit trajectories and valuable diversification for taxable investors. In general, investment opportunities in Category 3 are limited in the taxable space, so we will focus on the first two categories in this post.
When comparing pre-COVID enrollment figures from the Fall of 2019 to the Fall of 2020 enrollment data (Figure 2), we see that the pandemic has added further stress on enrollment behavior, accelerating the pre-existing downward trend.
Figure 2: Change in Higher Education EnroLlment by Sector
Although higher education institutions are early in their annual reporting periods (fiscal year-end 2020 data captures Fall 2019 enrollment), sixteen private university “winners” with public credit ratings ranging from AAA to low-A equivalents, reported average student enrollment increases of 12% (with a median of 1.2%). This initial data compare favorably against the aggregate first-year student enrollment loss of 3.7% and continuing student enrollment loss of 2.0% observed for the Fall of 2019. Our belief that this this trend could continue through the pandemic-impacted Fall 2020 season further supports our constructive view on institutions in Category 1. Further, the bulk of taxable municipal issuance in 2020 has emanated from institutions in either Category 1 or Category 2, which has created additional investment opportunities within those categories, particularly as a diversifier to the U.S. investment-grade corporate market.
The preceding chart illustrates that the COVID-19 pandemic has accelerated the deterioration of select sector fundamentals, and we believe that the “losers,” or institutions not in either of the above three categories, can be reasonably expected to bear the brunt of the sector disruption going forward, thus accelerating the downward trajectory in their credit fundamentals.
Legal headwinds to Persist, but to What End?
While COVID-19 has laid bare the sector’s divergent trajectories, the pandemic has also introduced some broader event risk into the equation. Seemingly endless amounts of litigation have been brought against universities with the goal of achieving reduced tuition now that institutions transitioned into remote learning environments for the Spring and/or Fall 2020 semesters. In general, the litigation argues that tuition expenses cover both course credits towards a degree and a comprehensive “college experience.” And with the latter no longer being provided, institutions are in breach of contract. Research into some filings suggests that this contractual basis is not addressed, and raises the question: can a pandemic be reasonably considered a force majeure in that context? To date, PGIM Fixed Income is not aware of a plaintiff alleging that a college pulled a “bait-and-switch” on its students.
Given the lack of clarity around this issue, it is reasonable to expect the traditional the legal process (filing of charges, seeking of dismissals, etc.) to play out, which will likely leave the issue unresolved in the near term and remain unsettling for investors.
And although a class-action lawsuit is the worst-case scenario for investors, it is an outcome to which we assign a low probability. Given the diversity of issues regarding college student composition at any given university, there is a strong argument that such diversity diminishes the probability of class certification by adding complexity and reducing commonality among potential plaintiffs. This lack of homogeneity makes the mechanics of class actions more difficult to consider, which should reduce the resulting probability of a worst-case scenario.
Despite the above threats to the higher education sector, we believe the complexities around the issue will prevent this from becoming a material credit event for the sector. Further, these institutions we’ve identified as having attractive enterprise characteristics are currently in a place to better manage the associated risks.
While the COVID-19 pandemic has accelerated a divergence in the sector’s trajectories, the current environment also offers opportunities for active credit investors that focus on institutions in the categories that are defying the larger trends in higher education and eschewing those that are not. And in general, PGIM Fixed Income believes that the higher-education taxable municipals sector presents a relatively risk-remote investment opportunity for investors seeking high-quality, long-duration investments with the added benefits of sector and credit diversification.
This material reflects the views of the authors as of November 19, 2020 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.
Garrett Falzone
Garrett Falzone is a Principal and Head of Municipal Bond Research for PGIM Fixed Income. Mr. Falzone covers a variety of sectors including higher education, senior living and project finance. Prior to joining the Firm in 2015, he established the municipal strategy team at Jefferies, LLC focusing upon both investment grade and high yield municipal sectors. Earlier, Mr. Falzone was employed at Lehman Brothers in the high yield municipal sales and trading and prior to Lehman oversaw all municipal high yield credit at BlackRock. Mr. Falzone earned a BS in Finance from Rider College and an MBA in Finance from New York University.
PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level or skill or training. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Netherlands B.V. located in Amsterdam; (iii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; (iv) the public fixed income unit within PGIM (Hong Kong) Ltd. located in Hong Kong; and (v) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore (“PGIM Singapore”). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Prudential, PGIM, their respective logos, and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.
These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM is not acting as your fiduciary. These materials represent the views, opinions and recommendations of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM Fixed Income is prohibited. Certain information contained herein has been obtained from sources that PGIM Fixed Income believes to be reliable as of the date presented; however, PGIM Fixed Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. PGIM Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. All investments involve risk, including the possible loss of capital. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or an y investment management services and should not be used as the basis for any investment decision. No risk management technique can guarantee the mitigation or elimination of risk in any market environment. Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. PGIM Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of PGIM Fixed Income or its affiliates.
The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions.
Conflicts of Interest: PGIM Fixed Income and its affiliates may have investment advisory or other business relationships with the issuers of securities referenced herein. PGIM Fixed Income and its affiliates, officers, directors and employees may from time to time have long or short positions in and buy or sell securities or financial instruments referenced herein. PGIM Fixed Income and its affiliates may develop and publish research that is independent of, and different than, the recommendations contained herein. PGIM Fixed Income’s personnel other than the author(s), such as sales, marketing and trading personnel, may provide oral or written market commentary or ideas to PGIM Fixed Income’s clients or prospects or proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual and potential conflicts of interest is available in Part 2A of PGIM Fixed Income’s Form ADV.
In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418). In the European Economic Area (“EEA”), information is issued by PGIM Netherlands B.V., an entity authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands and operating on the basis of a European passport. In certain EEA countries, information is, where permitted, presented by PGIM Limited in reliance of provisions, exemptions or licenses available to PGIM Limited under temporary permission arrangements following the exit of the United Kingdom from the European Union. These materials are issued by PGIM Limited and/or PGIM Netherlands B.V. to persons who are professional clients as defined under the rules of the FCA and/or to persons who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). In certain countries in Asia-Pacific, information is presented by PGIM (Singapore) Pte. Ltd., a Singapore investment manager registered with and licensed by the Monetary Authority of Singapore. In Japan, information is presented by PGIM Japan Co. Ltd., registered investment adviser with the Japanese Financial Services Agency. In South Korea, information is presented by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean investors. In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 (paragraph (a) to (i) of the Securities and Futures Ordinance (Cap.571). In Australia, this information is presented by PGIM (Australia) Pty Ltd (“PGIM Australia”) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). PGIM Australia is a representative of PGIM Limited, which is exempt from the requirement to hold an Australian Financial Services License under the Australian Corporations Act 2001 in respect of financial services. PGIM Limited is exempt by virtue of its regulation by the FCA (Reg: 193418) under the laws of the United Kingdom and the application of ASIC Class Order 03/1099. The laws of the United Kingdom differ from Australian laws. In South Africa, PGIM, Inc. is an authorised financial services provider – FSP number 49012. In Canada, pursuant to the international adviser registration exemption in National Instrument 31-103, PGIM, Inc. is informing you of that: (1) PGIM, Inc. is not registered in Canada and is advising you in reliance upon an exemption from the adviser registration requirement under National Instrument 31-103; (2) PGIM, Inc.’s jurisdiction of residence is New Jersey, U.S.A.; (3) there may be difficulty enforcing legal rights against PGIM, Inc. because it is resident outside of Canada and all or substantially all of its assets may be situated outside of Canada; and (4) the name and address of the agent for service of process of PGIM, Inc. in the applicable Provinces of Canada are as follows: in Québec: Borden Ladner Gervais LLP, 1000 de La Gauchetière Street West, Suite 900 Montréal, QC H3B 5H4; in British Columbia: Borden Ladner Gervais LLP, 1200 Waterfront Centre, 200 Burrard Street, Vancouver, BC V7X 1T2; in Ontario: Borden Ladner Gervais LLP, 22 Adelaide Street West, Suite 3400, Toronto, ON M5H 4E3; in Nova Scotia: Cox & Palmer, Q.C., 1100 Purdy’s Wharf Tower One, 1959 Upper Water Street, P.O. Box 2380 – Stn Central RPO, Halifax, NS B3J 3E5; in Alberta: Borden Ladner Gervais LLP, 530 Third Avenue S.W., Calgary, AB T2P R3.
© 2021 PFI and its related entities.
