Municipal Bond News 2/12/24

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Bull Case For Muni Bonds…Slower Rate Cuts…Golden State’s Limited Credit Upside…State Pensions Boosted… U.S. States Mull Fading Gas Tax…Bondholders Seek PREPA Debt Hearing Delay…Tax Scrutiny For HNWs…

Bull Case For Muni Bonds…Higher taxable equivalent yield relative to comparable United States Treasury bonds, potential price appreciation, and solid credit conditions make a bull case for muni bonds. Muni bonds offer a taxable equivalent yield close to 6% for top earners. That’s about 1.5% higher than Treasury yields. Muni bond yields are currently about 50 basis points higher relative to 15-year average. In 2024, bond yields are expected to trend lower. Even small rate cuts will boost muni bond returns and wipe off cash yields. The bear market for bonds ended last year. Yields were volatile last year, although 2023 ended with positive returns for state and local government bonds. Over the past eight Fed tightening cycles, bond yields were down by a full percentage point, on average, after the final hike. The Fed is done raising rates, and the magnitude and timing of the earliest rate cut is being debated. Inflation is closer to normalized and projected slower economic growth could set the stage for equity-like returns from bonds. Muni bonds have rallied since yields peaked last October. There is value in bonds issued by state and local government bonds. “One of the keys is for investors to not wait too long,” an expert said last week, “It’s really important in this environment to be looking forward, not behind.”

Slower Rate Cuts…Bond markets have dialed down the pace of rate cuts. Futures markets anticipate four or five rate cuts in 2024, down from wagers of seven rate cuts earlier. The Fed’s latest projection suggests three 25-basis point rate cuts this year. The Fed must “stay the course” to ensure inflation returns to the central bank’s 2% target, Atlanta Fed President Raphael Bostic added that “If we see a new spike of inflation or something like that, that will be very disruptive, and we want to avoid that to the extent that we can.” Dallas Fed President Lorie Logan noted that the disinflation progress so far “tremendous” but added that there’s more work to do, adding “I’m really not seeing any urgency to make any additional adjustments to rates at this time while we get a better understanding and build our confidence whether the progress that we’ve seen in inflation will be sustained over the medium run.” Boston Fed President Susan Collins said that “it will likely become appropriate to begin easing policy restraint later this year.

Golden State’s Limited Credit Upside…The question now is whether California revenue has stabilized or could turn lower. Golden State budget surpluses are now a distant memory. Rating agencies are optimistic that the Golden State will sail through in a broadly positive manner. However, underperforming tax collections limit room for credit upside on California general obligation bonds. “We anticipate a budget consistent with the executive proposal should allow the state to retain very strong gap-closing capacity, supporting the ‘AA’/Outlook Stable Issuer Default Rating,” Fitch said last week. S&P echoed that softer economic conditions could leave limited room for upside but should allow sufficient momentum for a positive outcome. For the last two years, state general fund revenue has underperformed budget. Surplus to outsized budget gaps highlight California’s volatile revenue cycles.

State Pensions Boosted…U.S. state pension funding is at its highest since early 2022. Aggregate funded ratio for U.S. state pension plans ended 2023 at 81% or 7.7% higher than a year ago, per Wilshire. The year-end rally in financial markets led to an improved funded ratio. Pension funding levels vary across U.S. states. Illinois, the lowest-rated U.S. state, saw its unfunded pension liability grow to $142 billion at year-end, up about 1.8% from a year ago. The climb in unfunded liabilities comes after teacher salaries were hiked last year, among other factors. Illinois, New Jersey and Connecticut are among U.S. states that boosted pension contributions in recent years to shore up state pensions.

U.S. States Mull Fading Gas Tax…Transportation is seeing a big surge in state funding. The surge comes as motor fuel tax collections have declined over the last decade due to the rise of electric vehicles. The federal gas tax was last raised in 1992, and is not inflation-indexed. Congress has held several hearings on the looming insolvency of the federal Highway Trust Fund. The Stop EV Freeloading Act to raise federal taxes on EVs was proposed by lawmakers last year. Hawaii is the first U.S. state to impose a per-mile fee on EVs to offset the fading motor fuel tax. Tennessee is eyeing private activity bonds along with a general fund infusion to boost transportation spending. An expert said, “It’s not going to be one silver bullet but a combination of solutions to replace lost gas tax revenue.”

Bondholders Seek PREPA Debt Hearing Delay…Bond Trustee, bond insurers and bondholders have asked the Title III court to postpone a March hearing on the PREPA debt plan until after the U.S. Court of Appeals rules on the revenue lien granted to bondholders. “While the outcome of the appeal is uncertain, that outcome may require significant amendments to the plan and disclosure statement, or even a new plan,” the bondholders told the Puerto Rico court. Puerto Rico’s fiscal agency is not in favor of extending the hearing date. A postponement of the debt confirmation hearing could allow “further examination of the facts. I would consider any rush to judgment which results in different treatment for bondholders as antithetical to objectives of PROMESA and the protection of creditor’s rights,” a former oversight board member said. The U.S. Court of Appeals ruling on the extent and strength of bondholders’ lien on the Island’s electric utility revenue carries broad implications for revenue-secured bonds.

Tax Scrutiny For High Net Worths…Millionaires have been forced to shell out taxes worth more than $500 million to the IRS since 2022. Focused tax enforcement on high income households and corporations is an outcome of the $80 billion federal funding boost from the 2022 Inflation Reduction Act. The funding boost will allow the IRS to generate $561 billion in tax revenue. That’s an average return on investment of $6 for $1 invested. IRS funding has pitted Republicans against Democrats. Republicans have been fighting to claw back the funding boost, arguing it will make the agency intrusive. IRS funding finds itself in a roiling political debate. Much depends on who wins the presidential election. The IRS wants to reverse a decade of declining audit rates.

Compare 30-Year taxable U.S. Treasury yield 4.36% to 30-Year tax-exempt Municipal Bond yield “AAA” 3.66%; “AA” 3.91%%; “A” 4.12%%. For investors in the 35% tax bracket, a 3.6% tax-exempt yield is equivalent to a 5.5% taxable yield. Top-rated long-term tax-free bonds yield 84% of comparabletaxable U.S. Treasuries.