Week of 2/14/2022

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Municipals Inflows Amid Higher Rate Hike Odds… Garden State Trims Debt… The Case For Illinois Rating Upgrade… Population Woes… State Tax Cuts Gain Controversy…

Municipals Amid Higher Rate Hike Odds… Traders assign 96% odds of a 50 basis points rate hike in March 2022, instead of 25 basis points earlier. Overall CPI index is up 7.5% in January from a year ago, higher than a 7% pace in December. “I’d like to see 100 basis points in the bag by July 1,” stated St. Louis Fed President James Bullard. Meanwhile, last week’s inflows to muni bonds snapped three weeks of outflows. Investors added about $216 million to municipal bond mutual funds during the week ended Wednesday per Refinitiv Lipper US Fund Flows data. January 2022 saw outflows aggregating close to $3 billion after 2021 brought over $60 billion inflows to muni bonds. The specter of rate hikes has made some investors cautious about investing in muni bonds, while others are ‘ambivalent’. A Black Rock analyst said, “The market has done a good job resetting, so we feel as though the short term pain in Q1 will be rewarded with longer term gains and a better entry point once we get out of Q1. “Credit quality has been spectacular in the last year,” another institutional investor added, “It feels like everything is on sale.” Households have a lot of cash waiting to be invested. No one knows how long an outflow cycle, which was interrupted by last weeks’ inflows, could last. A Citigroup analyst said, “While we envision the possibility of better entry points in the next 4-6 weeks, we have conviction that yields will ratchet back down before the end of the year and wind up at levels that are close to what we expected at the start of the year.”

Garden State Trims Debt… New Jersey’s early debt retirement has partially off-set its COVID-19 emergency borrowing that needed Supreme Court intervention. A Goldman Sachs alum, Governor Murphy shunned the Federal Reserve’s COVID-19 related borrowing facility, the Municipal Liquidity Fund or MLF, and headed to the municipal bond market for a $4 billion emergency borrowing when faced with the pandemic in 2020. No one complained about record low bond yields secured by the Garden State, but the higher debt load was not voter approved and drew criticism. New Jersey consistently ranks among the nation’s most indebted states with over $40 billion of debt. Soaring tax revenue and record federal aid led to a rethink on whether the additional debt was necessary. In response, a $3.7 billion debt relief fund was set up with the state’s budget surplus. The debt relief fund allocates $2.5 billion for paying off prior high coupon bonds, and another $1.2 billion is set aside for funding debt-free capital projects. The early payoff will bring $607 million of savings over 10 years. New Jersey is not alone in the pursuit of debt avoidance to better credit standing. Illinois won accolades from ratings agencies when it paid off all of its COVID-19 related borrowing from the Federal Reserve’s MLF sooner than anticipated. Connecticut’s first ratings upgrade in two decades came after Governor Lamont’s famed ‘debt-diet.’

The Case For Illinois Rating Upgrade “I believe Illinois is due to be recognized for our current achievements and plans to further strengthen our financial situation, and I believe these are strong indicators that favor upgrading Illinois’ credit rating,” Illinois controller wrote to ratings agencies on February 4 stating, “That Illinois has held steady in paying its bills should help ease concerns that the reduced backlog amount was just a temporary accomplishment.” The state controller highlighted supplemental pension payments sought in the Governor’s budget. The February 4 letter urged, “If this information is not sufficient to lead to a favorable review, Governor Pritzker’s recently announced budget proposal will surely check off any remaining doubts that Illinois is on the right track to fiscal stability.” “I am hopeful this will be welcome news to you and that your ratings agencies will reward Illinois with yet another credit upgrade.” Overall, ratings agencies’ analysts have praised the steps envisioned in the budget. Any word on a ratings upgrade is welcome news for Illinois’ bondholders.

Population Woes… Illinois was one of three U.S. states that saw its population drop in the recent census. For the second year in a row, California population fell with 173,000 fewer Californians in 2021 than a year ago. Although a hot spot for New York City residents fleeing to the suburbs amid the pandemic, Connecticut has consistently lost population over the last decade, shedding a net of 178,572 residents since 2010. Meanwhile, a spate of new arrivals have boosted the coffers of Idaho, the fastest growing U.S. state. Trump-era caps on state and local government tax (SALT) deductions on itemized federal tax returns, unlikely to be rescinded in the near future, have often been blamed for causing outmigration from high tax states. Overall, U.S. population growth in 2021 reached its slowest rate since the nation’s founding, eclipsing the previous record for slowest population growth set in 1918-1919, during the Spanish flu pandemic and World War I. Tax burden fueled a trend of outmigration from higher tax states.

State Tax Cuts Gain Controversy… Vexed with outmigration, high tax states look to cut taxes. Illinois, Connecticut and California want to use overflowing state coffers to cut taxes, a tactical move to tackle outmigration. Republican governors in Indiana and Missouri have joined Democratic counterparts in California, Connecticut, Illinois, Michigan, Minnesota and Wisconsin in proposing some form of tax cuts. Given neighboring states’ tax cuts, Governor Pritzker is compelled to set competitive tax policy and Illinois can afford to do so. Revenue outperformance $1 billion in the first half of Fiscal 2022 is planned for a $1 billion Illinois tax relief package. In Connecticut, Governor Lamont’s $336 million tax relief plan is centered on the municipal property tax, which generates more revenue than any state or other local tax. Stimulus rebate checks are likely for Californians for a second year in a row. Under an early budget action, Governor Newsom has outlined an additional $6.1 billion in tax relief for California restaurants and small businesses. There is leeway in using revenue outperformance for tax cuts, but states and locals are barred from using federal aid for direct tax relief. A half-dozen states have filed lawsuits challenging the bar on using America Rescue Plan direct aid for tax cuts, arguing that the mandate violates the anti-commandeering and spending clauses of the U.S. Constitution. Three federal district courts have granted injunctions barring the Treasury Department from enforcing the mandate. In the event of conflicting opinions from federal appeals courts, a showdown in front of the U.S. Supreme Court is not out of question. Incidentally, Pritzker Lamont and Newsom face re-elections in 2022. Revenue windfall gives states a leg up in tackling outmigration.

Compare 30-Year taxable U.S. Treasury yield 2.27% to 30-Year tax-exempt muni bond yield “AAA” 2.0%; “AA” 2.31%; “A” 2.70%; “BBB” 3.08%. For investors in the 35% tax-bracket, a 3% tax-exempt yield is equivalent to a 4.6% taxable yield. Top rated tax-free bonds yield 88% of comparable taxable U.S. Treasuries.