Municipal Bond News 8/21/23

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Municipal Bonds Outperform…Bellwether Bond Yields Near Multi_Year High…Higher-For-Longer Policy Rates Likely…Fed Committed to Fighting Inflation…U.S. States’ High Liquidity… Large Cities Face Mix of Challenges… Toll Road Muni Bonds’ Resilient

Municipal Bonds Outperform… Long-term investors view the current selloff in U.S. Treasury bonds as an opportunity to buy tax-free bonds issued by states and local governments, known as muni bonds. Higher investor competition to buy tax-free bonds has led muni bonds to outperform. In July, new muni issues were oversubscribed by 5.2 times on average, above the year-to-date average of 4 times per Bloomberg. Municipal bonds returned 0.4% in July, outperforming a 0.35% decline in comparable U.S. Treasuries. So far in August muni bond benchmarks lost 0.8%, outperforming both U.S. Treasuries and corporates, which lost 1.2% and 1.8% respectively. Most holders of muni bonds prefer not to sell muni bonds. Replacing tax-free income has become harder, as a shortage of new muni issue supply has persisted. States and locals are issuing new muni bonds at the slowest pace since 2019. Some investors reckon that taxpayers will ultimately pay for the highest federal borrowing costs in years, fueling prospects of rising taxes and lower future economic growth. Over time, such a scenario could be favorable for muni bondholders.

Bellwether Bond Yields Near Multi_Year High…U.S. Treasury yields rose close to multi-year highs. The 30-year Treasury yield, 4.37% last week, hit its highest level since 2011. That is four times higher than the 1.2% yield in 2020. The yield on the 10-year Treasury rose above 4.32% last week, within striking distance of the October 2022 top of 4.335%. The two-year U.S. Treasury note’s yield briefly topped 5%. Several factors have contributed to the surge in bellwether yields. Higher-than-usual issuance of Treasury bonds, waning demand from large Treasury buyers such as Japan and China, and Fitch’s August 1, 2023, downgrade of the U.S. sovereign credit rating has contributed to higher market yields. Also pushing up market yields is a stronger-than- expected U.S. economy that has boosted the case for additional fed-funds rate hikes. The U.S. economy is expected to grow 5.8% in the third quarter per Atlanta Fed’s forecast, the strongest pace since 2020. Since the start of August 10-year U.S. Treasury yield has surged 30 basis points, and tax-free state and local government bond benchmark yield has climbed 20 to 25 basis points.

Higher-For-Longer Policy Rates Likely… The likelihood of additional rate hikes has risen. Policy rates could remain at generational highs through the middle of next year.  Recession calls have faded.  Stronger-than- anticipated retail sales, housing starts, and industrial production make the case for a soft landing for the U.S. economy. Inflation remains well above the Fed’s 2% target. A robust U.S. economy suggests that it could take longer for the Federal Reserve to chip away at inflation. This has led investors to push out their expectations for when central banks will be able to start cutting interest rates. Bond markets assign higher chances of a peak funds rate of 5.75% by January, up from 5.25-5.5% currently. While inflation is moderating from last year’s peak, a stronger-than- expected economy has fueled a debate on how many additional rate hikes could be in store and for how long interest rates could remain high.

Fed Committed to Fighting Inflation…… “With inflation still well above the Committee’s longer-run goal and the labor market remaining tight, most participants continued to see significant upside risks to inflation, which could require further tightening of monetary policy,” Minutes of the Federal Reserve July 26 meeting noted. A broad inflation gauge, the consumer price index ran at 3.2% annual rate in July. The Fed has made progress in curbing inflation which peaked above 9% in June 2022. In the 1970s, central bankers raised rates to fight double-digit inflation but backed off quickly when prices showed tentative signs of backing off. Fed officials worry that declaring victory too soon could repeat mistakes of the past.

U.S. States’ High Liquidity…Some states have roughly twice as much cash in reserve compared to just a few years ago. “Prior to the pandemic, we saw states have around 10%,” a S&P analyst added “Right now we’re seeing those numbers at close to 20%.” High liquidity has helped U.S. states maintain high credit ratings and stay away from new debt. However, lower-than-expected tax revenues, inflation, stock market turbulence and higher Medicaid costs, could lead to projected deficits for some U.S. states. Economic uncertainty, political clashes in Congress, unexpected disasters and potential fiscal help to large urban centers are among challenges looming on the horizon for U.S. states.

Large Cities Face Mix of Challenges…Some of the world’s biggest landlords, Brookfield Corp. and Blackstone Inc., have filed for property tax assessment cuts. Lower commercial real estate valuations are looming large on large cities. Reduced assessments can lower city tax revenue. As an example, San Francisco tax filers have appealed for significantly lower property tax assessments. More than half of appeals have received a reduction, forcing the city to refund millions of dollars to property owners. On the east coast, New York City could face a cumulative budget gap of $40 billion over the next four years amid inflation and soaring costs to shelter migrants. NYC Mayor Eric Adams asked the White House to send more aid, but with some success so far. Some large cities are leaning on state governments to help navigate challenges.

Toll Road Muni Bonds’ Resilient…A humming economy brings cheer to toll road muni bonds. High traffic volumes, toll-rate increases and rebound in travel demand is a boost. Despite high fuel prices, traffic at toll roads has recovered. Vehicle miles travelled in 2022 is just 2.8% lower than 2019 per Federal Highway Administration. Toll roads’ strong rate-setting ability comes from the sector’s inelastic demand. Inflation-linked tolls partially offset a surge in maintenance costs. Ratings agencies expect the toll road sector to maintain strong overall finances. Toll roads are among the most resilient muni bond sectors, with hardly any downgrades during the pandemic.

Compare 30-Year taxable U.S. Treasury yield 4.43% to 30-Year tax-exempt Municipal Bond yield “AAA” 3.86%; “AA” 4.22%; %; “A” 4.39%. 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 87% of comparable taxable U.S. Treasuries.