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Why More Investors Are Putting Money Into Tax-Free Bonds…Amid falling interest rates and rising taxes, wealthy individuals are turning to municipal bonds. The top income tax bracket could rise to 39.6% from 37% currently if the 2017 Tax Cuts and Jobs Act expires in 2025. Higher taxes boost the value of muni bonds’ tax shelter. For example, a 5% tax-free coupon is equivalent to 7.9% taxable yield under a 37% federal income tax, and 8.25% under a 39.6% federal income tax rate. The $10,000 cap on state and local tax deductions has led investors to seek refuge in muni bonds, particularly in high tax states such as New York and California. Demand for muni bonds has accelerated this year. It is hard to predict the fate of the major tax reform, which hinges on the presidential election’s outcome. However, the U.S. government faces a persistent gap between federal spending and tax collections, driven by higher interest costs and social spending for an aging demographic. The U.S. budget deficit topped at $1.8 trillion in Fiscal 2024, and is projected to increase in coming years, fueling the case for future tax hikes.
Orders Flood For New Muni Bonds…Some recent high yield tax-free bonds are oversubscribed fifteen to thirty times, while high grade muni bonds are seeing orders worth three to eight times the volume of new muni bonds issued. Recently, an unrated charter school muni bond issue saw competing orders worth 31 times the amount of long-term bonds issued, with yields cut 30 basis points. Outsized inflows to high yield bond funds have led to the large oversubscriptions. A likely soft-landing for the U.S. economy bodes well for lower-rated issuers. Lower rates ahead will shore up capital access for such junk rated borrowers. High yield muni bonds have returned close to 6.8% this year, outperforming a broad muni bond index return of 1.7%.
Bellwether Yields Rise…U.S. Treasury yields have risen 40 basis points in October, whereas muni bond yields have risen 20 basis points over the same period. U.S. Treasury bonds have declined for four straight weeks, the worst streak since April. Yields on 10-year notes are back above 4%, and the 30- year bond’s yield touched 4.42%, the highest level since July 30. Amid volatile markets, long term state and local government bond yields rose 14 basis points last week. Muni bond yields are currently the highest since July.
Pace of Rate Cuts…Bond markets have assigned roughly 20% odds for the Fed to pause rates at the November meeting. Expectations on the pace of rate cuts shifted after September inflation was higher than expected. September inflation fell to a 2.4% annual pace, down from 2.5% in August. Fed officials were divided on the size of the first rate cut, minutes of the Fed’s latest meeting revealed. Some Fed officials, including New York Fed President John Williams, mostly shrugged off higher-than-expected consumer inflation and signaled they support continued rate reductions. However, Atlanta Fed President Raphael Bostic said he would consider a pause in rate cuts, and Dallas Fed President Lorie Logan reiterated Friday that interest rates should move at a slow pace to a more normal level.
Airport Bond Supply Boom…Airports’ muni bond issuance has doubled from last year. Airports have sold over $12.3 billion new muni bonds this year. An influx of air travelers has fueled a borrowing boom for expansion projects. More than 100 million people flew through American airports in June, the highest number of passengers since at least 2003. The 10 largest US airports will need between $55 billion and $75 billion of infrastructure improvement over the next few years, per Wells Fargo. Eventually, this supercycle of airport capital improvements could wane. Sacramento, Charleston, Fort Myers airports have recently issued new muni bonds. This week, Chicago O’Hare airport is issuing $1.5 billion new muni bonds. An airport bond index has returned 8.4% over the past year.
Chicago Public Schools’ Governance Battle…The nation’s third largest school district is grappling with governance changes and union challenges. Last week, Mayor Johnson named a new school board, after all seven board members resigned abruptly last week. Tensions on a teachers’ contract and financing issues are said to have caused the rift. Chicago Public School will hold its first board election next month. In January, the school board will triple in size to include 11 mayoral appointees and 10 elected members. Chicago faces a nearly $1 billion deficit next year, the most since the pandemic.
States Eye Higher Taxes…State tax hikes are back on the table. The shift comes after 48 U.S. states cut taxes between 2021 and 2023. Slower state revenue growth and the end of federal pandemic aid is forcing states to seek higher taxes. Earlier tax cuts, be they one-time reductions, property tax caps, expanded exemptions, and rebates to taxpayers, are being reconsidered. Fewer U.S. states have cut taxes in Fiscal 25 budgets, a return to more typical state budgeting. In 2025, some states are dipping into accumulated balances for one-time spending and others tapping rainy day funds to help balance their budgets.
Top Muni Issuers…The Lone Star state has claimed the top spot for muni bond issuance. Texas has issued the most muni bonds this year, followed by New California and New York. Florida has seen bond issuance surge 117% from a year ago. Bond volume in 2024 is on pace to break previous issuance records. Over $380 billion muni bonds have been issued in the first three quarters of 2024, which exceeds 2023 annual issuance of $384 billion. 2020 holds the record for highest primary muni market volume, when $484 billion muni bonds were sold. For supply this year to beat 2020’s record high, there would need to be more than $87 billion in muni bond issuance for the remainder of 2024.
Compare 30-Year taxable U.S. Treasury yield 4.42% to 30-Year tax-exempt Municipal Bond yield “AAA” 3.67% “AA” 3.99%; “A” 4.12%. For investors in the 35% tax bracket, a 3.7% tax-exempt yield is equivalent to a 5.7% taxable yield. Top-rated long-term tax-free bonds yield 84% of comparable taxable U.S. Treasuries.