Week of 12/6/2021

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Illinois Bond Penalty Lower… Bonds Rally… Fed Could Shift From Hikes to Cuts in 2025… SALT Implications… Federal Aid Boosts State Spending… Growing Cannabis Revenue… Puerto Rico Revenue Trends Higher… 2022 Municipal Bond Supply…

Illinois Bond Penalty Lower… Investors cut the yield penalty for the lowest rated U.S. state’s bond sale. Credit spread or the yield gap from top rated tax-free bonds ranged from about 52 basis points for ten-year bonds to 116 basis points for twenty- year paper. A year ago, Illinois bond spreads were much higher, ranging from 97 to 297 basis points, as were its financial woes. Today Illinois general fund revenue from state sources is 17% higher than a year ago. A vast improvement in financial outlook is reflected in a bigger surplus this fiscal year and smaller gaps over the next four years. The state has paid off $2.3 billion of the total $3.2 billion borrowed last year from the Federal Reserve to fight COVID-19. Its infamous bill backlog is down to $4 billion, down 27% from pre-pandemic levels. Illinois bonds are much sought by tax-free investors seeking higher yields. The state’s successful bond sale is likely to favor other Illinois issuers, such as Chicago, which offers tax-free bonds in the week ahead.

Bonds Rally… Long term Treasury bond yields fell to lowest in a year. 30-year Treasuries yield 1.67% last week, down from a yearly average of 1.88%. Tax-free municipal bonds yield 1.54% for 30 years. The Muni Treasury Ratio, a measure of relative value rose to 91%, signifying value pricing of tax-free bonds. The fall in long term yields combined with the rise in the short term yields has flattened the yield curve. The yield gap between 10-year and 30-year U.S. Treasuries is only 32 basis points, the lowest since January 2019. Traders expect the Federal Reserve to hike benchmark short term rates after mid-2022. A flatter yield curve is a leading indicator of lower inflation and slower growth.

Fed Could Shift From Hikes to Cuts in 2025… The Fed’s preferred measure of inflation has stayed elevated for longer than policymakers had expected. However, many forecast inflation will cool next year as supply chain issues are resolved, therefore, inflation should subside considerably by 2024. Short term interest rate traders have concluded that the U.S. economy won’t be able to withstand Fed hikes after 2024. They’ve begun to price in rate cuts in 2025 following a maximum of five 25 basis point increases, inverting the Eurodollar futures curve from December 2024 to December 2025. European traders subsequently priced in an earlier start to rate hikes than the Fed, while leaving the expected terminal rate well below the Fed’s projection. The cycle European traders expect to begin in June 2022 delivers rate cuts equal to 130 basis points, equivalent to just over five 25 basis point moves by the end of 2024. On the other hand, the Fed currently envisions the possibility of two additional hikes by the end of 2024 and potentially five hikes vs market expectations by the end of 2025.

SALT Implications… Hotly debated State And Local Tax (SALT) deductions have divided Democrats. Senator Bob Menendez of New Jersey wants unlimited SALT deductions, while Senator Bernie Sanders of Vermont seeks to exclude the wealthy from unlimited SALT deductions. The House version of Build Back Better raised the cap to $80,000 regardless of income until 2030. Republicans established the $10,000 cap on the SALT deduction to raise revenue to help offset the corporate tax cuts and lower individual tax rates in Tax Cuts and Jobs Act of 2017. Democrats’ criticism of the SALT cap contributed towards them flipping a number of affluent, suburban districts in the 2018 mid-term elections. SALT has implications for next year’s midterm elections.

Federal Aid Boosts State Spending… U.S. states spent $2.65 trillion in Fiscal 2021, 16% higher than prior year. The splurge was driven by unprecedented federal aid and sharp revenue growth. Fiscal 2021 marked the first time federal funds have represented the most significant single funding source for total state expenses, surpassing states’ general funds. Debt service accounts for about 3% to 4% of state spending. States have spent over $427 billion of COVID-19 related federal aid so far and have until the end of 2024 for earmarking federal aid-related spending.

Growing Cannabis Revenue… Cannabis tax revenue could exceed taxes collected by some states on alcohol within a few years. Cannabis taxes aggregated to more than $2 billion last year and could grow to $10 to $12 billion by 2030 per Barclays. 18 states have legalized marijuana. In 2021, New York, New Jersey, Connecticut, Virginia and New Mexico legalized recreational marijuana. California leads in cannabis tax collections.

Puerto Rico Revenue Trends Higher… The Island’s tax collections continue to soar higher. “The line of taxes on income contribution showed an upswing over what was expected with rates that range between 28% and 30%, with respect to Fiscal 2021,” Puerto Rico Treasury Secretary added “In addition, we continue to observe strong growth in sectors related to consumption.” The Island’s general fund revenues were 17% above Oversight Board projections and 10% above prior year for the first quarter of Fiscal 2022. The outperformance was echoed in sales and use tax collections, which were 15% above prior quarter and 10% above board estimates. Fiscal outperformance is favorable for Puerto Rico bonds.

2022 Municipal Bond Supply… Fewer municipal bonds will be issued in 2022, majority of forecasters anticipate. About $470 billion municipal bonds could be issued next year on average, eleven Wall Street firms estimate. This year, $427 billion bonds have been issued. 2020 holds the record for the highest municipal bonds issued. Bank of America’s estimate of $550 billion municipal bonds next year appears to be an outlier. Federal infrastructure funding, excess federal aid and fewer voter approved bonds at the November ballot could temper government borrowing. Another dampener to tax-free bond supply is that the House approved Build Back Better legislation does not provide open access to tax-free bonds for refinancing prior debt. To the extent new variants could potentially prolong the pandemic, governments are likely to delay new borrowing amid uncertainty.

Compare 30-Year taxable U.S. Treasury yield 1.70% to 30-Year tax-exempt muni bond yield “AAA” 1.54%; “AA” 1.69%; “A” 1.91%; “BBB” 2.40%. For investors in the 35% tax-bracket, a 2.4% tax-exempt yield is equivalent to a 3.69% taxable yield. Top rated tax-free bonds yield 91% of comparable taxable U.S. Treasuries.