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Week of 06/14/2021
Ten Reasons Tax-free Muni Bonds Are Scarce
A series of factors have conspired to cause a ‘food fight’ for retail investors seeking tax-free bonds. Ravenous appetite for tax-free bonds, particularly higher yielding ones, has compressed the yield gap between high and low rated municipal bonds. State and local government revenue dipped by a mere1% on average in 2020, while states and cities received hundreds of billions of dollars of federal cash. Compared to the Great Recession, the Covid-19 health crisis saw restrained debt issuance by states and local governments. The Federal Reserve has advocated a patiently accommodative monetary policy stance. In the past decade, inflation did not reach 2%on a sustained basis. The wealthiest 1% of Americans, who hold up to $1.5 trillion in unrealized capital gains, are most concerned about President Biden’s Tax and Spend Robinhood gambit, which seeks to upend long standing tax advantages.
First and foremost, “We’re at a great inflection point in history,” President Biden wants to tax the rich and give to the middle class and poor. President Biden’s tax agenda seeks to hike income taxes, double the capital gains tax and close estate tax exemptions on the wealthiest. The Democrat controlled federal government has brought a policy shift not seen since WWII. Half a million wealthy households could end up footing the bill for trillions of dollars offer Federal spending. Tax-shelter as an investment strategy is a priority for the wealthy Americans more than ever before.
Second, orders for higher yielding tax-free bonds far outnumber the amount of bonds on offer in the new issue market. Some high yield bond issues are oversubscribed as much as thirty times, which pushes yields lower. Example, an unrated California senior living facility issued new 35-year bonds at a yield of 4.43%, about 2.5% less than planned and yields fell to 3.43% in secondary trading. New Jersey Transportation Trust Fund’s $1.5 billion new bonds rated Moody’s “Baa1” S&P “BBB” Fitch “BBB+” were twenty times subscribed, repriced to lower deals and brought historically low yield penalty for the lower rated issuer. The trend of oversubscribed deals and lower yield penalty is rampant across high yield tax-free bond sector, echoing High Net Worth investors’ search for tax-shelter and higher yields.
Third, trading of tax-free bonds is unusually thin. On average, about $9.3 billion worth of muni bonds changed hands in secondary market trades daily this year, the lowest in two decades. Dwindling number of muni bond trades, 32,500 daily average 2021, is a record low since 2005 per MSRB. Bondholders see no reason to part with tax-free income from municipal bonds. The muni market rally has given investors less incentive to sell since they would have to pay capital gains taxes. In contrast, corporate bonds and U.S. Treasuries delivered tax losses for investors. Municipal bonds are thinly traded, and held in tax-free portfolios for their duration.
Fourth, in the primary market, a growing number of muni bonds are issued as restricted for sale only to institutional investors. More than $6.5 billion high yield municipal bonds issued this year were restricted by the issuer for sale only to institutional investors, driving such issuance toward the biggest year on record.
Fifth, investors have added cash or average of about $1.9billion to municipal bond funds each week in 2021, more than quadruple the average since 2010, per Investment Company Institute. High yield bonds have got a fourth of $44.7 billion cash inflows to muni bonds in2021.
Sixth, more credit upside in lower-rated muni bonds is an outcome of multiple rounds of generous aid to COVID-19 hit muni bond sectors, such as airports, public transit and hospitals. Dire predictions of COVID-19 related government revenue losses never came true. Most states were adequately positioned to cover COVID-19 related fiscal 2020 budget gaps through structural budget adjustments, reserve funds or recurring, non-recurring measures. Backed by unprecedented federal aid, state tax revenue outperformed, and left some states, such as California, with the enviable predicament of distributing excess moneys to taxpayers. Connecticut won its first rating upgrade in twenty years. Reversing COVID-19 driven negative outlooks assigned last year, rating agencies have swiftly assigned stable or positive outlooks to many municipal bond sectors.
Seventh, states and cities are in no rush to borrow. Federal infrastructure funding could catalyze billions of federal and private dollars. Aggregate tax-supported state debt declined by 0.7% compared to Fiscal 2019, and median aggregate state debt fell by nearly 7.5% since 2009. Only three states saw their debt burden grow during Covid-19,Hawaii, Illinois, and New Jersey, have plans to payoff the Covid-19 related debt early or have significant surpluses. Growing volume of taxable bond issuance has brought a dearth of tax-exempt bond supply. One-in-three muni bonds issued in the primary market is taxable, a predicament for high net worth’s’ seeking tax-free income. Revival of federal interest subsidies for state and local government debt sales, could boost taxable bond volume, while depleting tax-exempt bond supply. Bond issuers’ wait-and-watch mode has left a lull in the muni market supply.
Eighth, peak reinvestment needs during summer months elevates demand for tax-free bonds. Municipal bond investors set to receive $180 billion tax-free cash from muni bond debt service during June to August. The amount of money that investors will receive from principal and interest payments on tax-exempt bonds will outstrip the volume of new sales by about $62 billion over summer per Citigroup estimates. It is cheaper than ever for governments to refinance prior debt. Many tax-free bonds are being paid off early as bond issuers seek to lock-in savings.
Ninth, Federal Reserve officials have repeatedly said they expect the price pressures to prove temporary. As a result, they’ve given no indication that they’re ready taper bond purchases or raise rates in the foreseeable future. Expectations for annual price gains are holding near 2% in the second half of next year. Reflecting declining expectations for price gains, the 10-year break even inflation rate has fallen 0.08% to 2.34% this week. There is a growing willingness among investors to accept the Federal Reserve’s mantra that higher inflation will prove transitory, settling down when the comparisons to last year’s locked down economy have run their course.
Tenth, negative yields overseas have propelled global capital towards U.S. fixed income market. Foreign investors’ muni bond holdings are at a record high. Banks worldwide, required to hold large quantities of very liquid, safe securities, have gravitated towards United States Treasury bonds. U.S. Treasuries yield a lot more than other sovereign bonds. Japanese bonds yield basically nothing, German ones have a negative yield. U.S. Treasury bond is the sovereign bond most preferred by global institutional investors. On top of that, the U.S. central bank is buying $80 billion of Treasuries a month. Strength of the U.S. Treasury market is a powerful tailwind for the $3.9 trillion municipal bond market. Municipal bonds are second in safety to none other than U.S. Treasuries.
High yield tax-free bonds are in the midst of the biggest rally since 2014. What a difference a pandemic and Federal Reserve commitment to keep rates near zero make. Institutional investors’ cash holdings soar higher in want of municipal bond supply; some are turning away money seeking to be invested in municipal bonds due to lack of tax-free bonds. Experts reckon that any rate or market volatility could be an opportunity to buy tax-free bonds. Upcoming federal infrastructure spending will boost state and local governments, ushering a golden era for municipal bonds.
Compare 30-Year taxable U.S. Treasury yield 2.15% to 30-Year tax-exempt muni bond yield “AAA” 1.46%; “AA”1.54%; “A” 1.75%; “BBB” 2.65%. For investors in the 35% tax-bracket, a 2.6% tax-exempt yield is equivalent to a 4%taxable yield. Top rated tax-free bonds yield 68%of comparable taxable U.S. Treasuries.
Information obtained from sources deemed reliable; GMS does not purport Review/Preview contains all available information.