Municipal Bond News 3/25/24

America’s Wealth Boom Favors Muni Bonds…Central Bankers Divided…Build America Bonds (BABs) Face Bond Calls…PREPA Debt Plan Hearing Ends…Chipping California’s Budget Deficit…Record High Federal Interest Costs…Golden State, Big Apple Tax Hike…Cities Face Demographic, Wage Pressures…

America’s Wealth Boom Favors Muni Bonds…More Americans are landing up in higher tax brackets. To blame is the nation’s booming wealth. High income earners have grown in numbers. Income tax return filings for earners above $1 million rose 44%, and filings from those earning between $500,000 and $1,000,000 grew 32% per latest IRS data. Overall, aggregate U.S. adjusted gross income crossed $2.2 trillion in 2021. The IRS findings correlate with record high tax collections by states and local governments post-pandemic that boosted the credit quality of muni bond issuers. The wealth boom is credit positive broadly for muni bond issuers. As wealth increases, so does the value of the tax shelter. Although yields are down from their recent highs, absolute yields are still attractive for investors in higher tax brackets. The taxable equivalent yield for a broad muni bond index is near 7% for investors in the top tax bracket. Amid the wealth boom and prospects of rising taxes, tax-free muni bonds are witnessing robust demand from investors.

Central Bankers Divided…The question of how many rate cuts will occur this year has divided Fed officials. Central bankers are split near-even. Ten Fed officials expect three or more quarter-point cuts this year, and nine anticipated two or fewer. The Fed has left its forecast of 2024 policy rates unchanged since December 2023. Fed continues to maintain its outlook for three quarter-point rate cuts this year but forecasts fewer cuts in 2025. Fed Chair Powell said, “If the economy evolves broadly as expected, it will likely be appropriate to begin dialing back policy restraint at some point this year.” The last time the Fed raised rates was at its July 2023 meeting. At last week’s Fed meeting, the Fed continued a pause on policy rates.

Build America Bonds Face Bond Calls…Several muni bond issuers are refinancing taxable Build America Bonds (‘BABs’) with lower-yielding tax- exempt bonds. Continual cuts to BAB interest subsidies over more than a decade led issuers to seek extraordinary redemptions of BABs. Not all investors are on board. Some investors oppose the extraordinary redemptions and have questioned the legality of a few recent refunding bond issues such as the Regents of the Univ of California. Issuers claim that federal subsidy cuts amount to an ‘extraordinary event’, a trigger for redemption. The recent outperformance of tax-exempt bonds has pushed tax-free yield below taxable yield, creating an opportunity for refinancing. Close to a third of BABs, $100 million outstanding, are poised to be called this year, experts estimate.

PREPA Debt Plan Hearing Ends…Judge Swain’s ruling is anticipated, as the Title III court hearing on the debt plan ended last week. While the Island administration is highlighting projections of growth in talks with rating agencies, it is trying to pay less to bondholders by cutting back debt affordability analysis that is “designed to reach a preordained result,” Syncora Guaranty and Golden Tree Asset Management stated at the hearing. The Island territory has posted economic growth in each of the five past years. Assured Guaranty claims PREPA is required to give bond parties the most it can afford, which the debt plan doesn’t. A much-awaited ruling from the U.S. Court of Appeals on the revenue lien granted to bondholders is pending and could throw the debt plan into limbo.

Chipping California’s Budget Deficit…Spending cuts and tapping rainy day funds could help shrink California’s budget deficit. Lawmakers are advancing a plan that calls for $3.7 billion in cuts, borrowing, fund shifts and deferrals in the current fiscal year, $13.4 billion in budget solutions for fiscal year 2024-25, and taps $12 billion from the rainy-day fund. Newsom estimated the state’s budget shortfall at $38 billion in January, which was later revised to $53 billion. In February, the Legislative Analyst’s Office raised its deficit to $73 billion. The Senate Budget Committee’s plan uses the governor’s $53 billion deficit estimate and reduces the shortfall to $24 billion. Welcoming the proposal, Newsom said, “The deficit we’re facing this year will require big solutions, and I appreciate the Senate’s plan to close California’s budget deficit by $17 billion.” Next week, California plans to issue $2.6 billion general obligation bonds.

Record High Federal Interest…United States will spend over $870 billion on interest payments on national debt. Over the next decade, interest expense could amount to over $12 trillion. That’s more the amount the national debt was, as recently as 2009. National interest payments, the third largest federal expense, behind Medicare and Social Security, outpace national spending on defense, transportation, education, housing and social services. National debt has climbed as the U.S. budget deficit has soared. The rising cost of interest payments could force spending cuts and tax hikes. Trillions of dollars of tax cuts since 2017 are on the chopping block.

Golden State, Big Apple Tax Hikes…Lawmakers favor raising the personal income taxes by half a percent for people earning over $5 million until 2027. Such an increase could add nearly a billion in new revenue each year. Faced with NY’s nation-leading population loss, Governor Hochul is opposed to income tax hikes. Policy experts defend the proposed tax hikes, stating that it is working and middle-class New Yorkers who led the exodus. In California, lawmakers seek new taxes on sales, regional payrolls or properties to fund massive budget shortfalls faced by Bay Area transit operators. The move echoes New York’s payroll mobility tax, enacted in 2021, which boosted MTA’s credit.

Local Government Face Demographic, Wage Pressures…Amid an aging demographic, cities and counties are likely to see a decline in working age. This could constrain local government revenue from property tax, utility and other revenues. Cities with relatively high unfunded pension liabilities will come under pressure to increase pension contributions. It could be politically challenging to expect fewer taxpayers to bear such costs. At present, local government are grappling with growing pressure to raise police and fire wages amid a competitive labor market. Public safety spending takes up half of the budget, for small and medium sized cities.

Compare 30-Year taxable U.S. Treasury yield 4.40% to 30-Year tax-exempt Municipal Bond yield “AAA” 3.69%; “AA” 3.96%; “A” 4.11%. 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.