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Municipal Bond News 2/27/23
Illinois Earns Rating Upgrade…Municipal Bond Yields Climb… Rate Hike Expectations Reset… Fed’s Inflation Gauge Higher… Strength of Economy Belies Expectations…U.S. States Divided on ESG Policy…Tax Hike Plan to Fix Social Security…
Illinois Earns Rating Upgrade…S&P upgraded Illinois general obligation bonds to ‘A -’ from ‘BBB+’ with a stable outlook. The upgrade takes the lowest-rated U.S. state to its highest S&P credit rating since 2016. Paying off unpaid bills, fully funding the annual statutory contribution and building reserves led to the credit upgrade. The trend of improved financial flexibility, transparency, liquidity and reserves is expected to continue in the Fiscal 24 budget cycle, S&P noted. Federal aid has helped Illinois pay off over $10 billion of debt over the last two years. Termed ‘credit positive’ by S&P, Illinois has amassed rainy day reserves of close to $2 billion or about 4% of general fund spending. High pension liabilities are a credit pressure. Transparency in financial reporting has vastly improved, but Illinois’ audit reporting still lags typical timeframes. Illinois Comptroller said that efforts to shore up the rainy-day fund will “hopefully” usher in more upgrades. The latest rating upgrade comes after a Fitch upgrade last year, following upgrades from both Moody’s and S&P in 2021. Governor Pritzker said, “I am thrilled to see our hard work at righting the past fiscal wrongs of our state reflected in today’s action by S&P with another credit rating upgrade.”
Municipal Bond Yields Climb…Mounting concerns that the Federal Reserve will continue to raise policy rates has erased most January gains for debt issued by states and local governments. The year-to-date return on top-rated municipal bonds is 0.55%, down from 2.87% at the end of January. Diminished returns on tax-free bonds follow an uptick in comparable United States Treasury yields. Bellwether 10-year U.S. Treasury yields have risen 35 basis points in February, the highest in three months. Rate -sensitive two-year U.S. Treasury yields stood at 4.81%, the highest since 2007. Top- rated long-term municipal bond yields have risen [40 basis points] over the last month. The prospect of rising rates tends to push down bond prices. Amid volatile market conditions, New York City sold $677 million tax-free bonds last week, on the heels of a $2.5 billion University of California bond sale earlier this month. Recently upgraded to ‘AA’ by Fitch, New York City bonds fetched a top yield of 3.36% tax-free.
Rate Hike Expectations Reset…Odds that Fed was nearing the end of its rate hike cycle were overturned by a robust economy. Futures markets estimate a peak fed-funds rate of 5.4% in September or October. That’s higher than a peak fed-funds rate of 5.27% estimated a week ago, and 5% at the start of the year. Notably, JP Morgan CEO does not rule out a peak policy rate of 6%. Last week, five Wall Street economists and academics suggested that peak rates between 5.6% to 6.5% later this year could inflict a recession. The Fed will provide its estimate of future rate hikes on March 21-22. Investors assign close to 40% odds of a half-point rate hike at the Fed’s March meeting.
Fed’s Inflation Gauge Higher…The Personal Consumption Expenditure (‘PCE’) Index, the Fed’s preferred gauge of inflation, rose 5.4% in January from a year earlier, higher than 5% consensus forecasts and up from 5.3% in December. From last month, the PCE Index rose 0.6%, a higher surge than December’s 0.4% monthly gain. Higher prices of goods, services, energy and food in January led to the price surge. Excluding volatile food and energy, core PCE Index was up 4.7% from a year ago. Year-over-year price gains peaked at four-decade highs last September and have mostly receded since then. However, the U.S. economy grew stronger in January, adding to price pressures. Federal Reserve Governor Philip Jefferson explained, “The ongoing imbalance. between the supply and demand for labor, combined with the large share of labor costs in the services sector, suggests that high inflation may come down only slowly.”
Strength of Economy Belies Expectations…Atlanta Fed projects real GDP will grow by 2.5% in the first quarter, upending its earlier estimate of 0.7%. Higher-than-expected January household spending and income have boosted economic growth expectations. January unemployment is at a 53-year low. 70 million Americans benefited from 9% higher social security income, from annual cost-of-living adjustments. Personal spending rose 1.8% in January from prior month, the largest increase in nearly two years, and a reversal from a small decrease in December. However, not all sectors of the economy are in high gear. The housing market is facing the onslaught of higher mortgage rates in February. Mortgage applications are the lowest in nearly 30 years and for-sale homes are sitting out in the market longer. For the 12th straight month, existing home sales fell in January. New home sales grew at a robust annual pace of 7.2% in January as mortgage rates eased last month, a short-lived reprieve. Warmer than usual weather and higher social security incomes have contributed to vibrant economic conditions at the start of 2023.
U.S. States Divided on ESG Policy…Amid a raging political debate, ESG-labeled municipal bond issuance has grown four-fold from less than $10 billion in 2019 to $40 billion in 2021 and 2022. In 2023, states and locals are expected to issue about $50 billion Environmental, Social and Governance (‘ESG’) labeled municipal bonds, about 25% higher than last year’s volume. Federal funding of $369 billion, from the Inflation Reduction Act, for climate-related projects is shaping U.S. state adoption of ESG principles. Democrat-led New Jersey and Minnesota are leading in climate initiatives. Meanwhile, Republicans such as Governor Ron DeSantis threaten to forego money managers and/or ratings agencies that include ESG factors in investment decisions and credit analysis. Republican led Texas has divested from money managers that favor ESG principles. A few Republican -dominated states, Kentucky and North Dakota, are going against their party’s anti-ESG stance. House Republicans are pushing back on the Biden administration’s efforts to bolster ESG investing. While a divided Congress is likely to stall new ESG-related federal laws, U.S. states are driving legislation on ESG matters.
Tax Hike Plan to Fix Social Security…To shore up social security, Senators Bernie Sanders and Elizabeth Warren want to raise the top federal income tax rate by a third, and the top federal capital gains tax rate by more than half. A new bill seeks to add a 12.4% payroll tax on ordinary income above 250,000, raising the top federal tax rate from 37% to 49.2%. Investment income above $250,000 would also incur a 12.4% payroll tax, in addition to the existing 3.8% Affordable Care Act surcharge and 20% capital gains tax. The proposal seeks to raise the federal capital gains tax from 23.85% to 36.2%.
Compare 30-Year taxable U.S. Treasury yield 3.93% to 30-Year tax-exempt Municipal Bond yield “AAA” 3.64%; “AA” 4.04%; “A” 4.55%. For investors in the 35% tax-bracket, a 4% tax-exempt yield is equivalent to a 6.15% taxable yield. Top-rated long-term tax-free bonds yield 93% of comparable taxable U.S. Treasuries.