Week of 4/11/2022

A Higher Tax Bill…Faster Rate Hikes… PREPA Debt Mediation Team…Federal Budget Boost For Government Issuers…Fitch Upbeat on Illinois Budget… Tax-Free Bonds More Resilient to Rising Rates…

A Higher Tax Bill… On Tax Day, High Net Worth’s tax bill will arguably be the highest in decades. The top 1% of earners pay close to 40% of taxes collected nationwide. The top 1% of U.S. earners paid a greater share of individual federal income taxes ($612 billion) than the bottom 90% combined ($461 billion) per Tax Foundation. Americans paid over $1.5 trillion towards annual federal income taxes per recent tax data, with an average tab of $10,000 for a household. State income tax, property tax and sales tax contribute toward tax burden. In Illinois, a median household pays $9,488 each year in state and local taxes, 39% more than the national average. In Hawaii, sales and excise taxes are the highest in the nation. Property taxes are the highest in Maine and Vermont nationwide. Low income tax doesn’t always mean low taxes as a whole. Texas residents pay no income tax, but spend 1.8% of their income on real estate taxes. In contrast, Californians pay just 0.76% in property tax, and spend almost 5% of their paycheck on income tax. The tax code is complicated, and income tax rates alone cannot explain tax variations across U.S. states. “Tax burden”, defined as a proportion of total personal income that residents pay towards state income tax, property tax and sales tax, is a gauge of tax climate. New York has the highest tax burden of 12.75% per WalletHub. California has a tax burden of 9.72%, and tax burden exceeds 10% in New Jersey and Connecticut. The states with the highest income tax rates all have graduated tax rates: California (13.30% top marginal tax rate), Hawaii (11% top marginal tax rate), New Jersey (10.75% top marginal tax rate). Caps on state and local tax deductions from itemized federal returns, which are unlikely to be rescinded in the near future, has elevated High Net Worth’s tax bills. Not only has the share of aggregate taxes paid by the top 1% of earners grown over the past two decades, but new tax hikes are being debated in Washington. Tax season is an opportunity for High Net Worth’s to renew search for tax-free municipal bonds.

Faster Rate Hikes… Federal Reserve officials are ready to shrink the central bank balance faster than anticipated and raise federal funds benchmark rates by 50 basis points at one or more future meetings, Fed Minutes released last week show. The Fed purchased approximately $4 trillion bonds during the pandemic for boosting liquidity and easier financing conditions during the global health crisis. In Fall 2021, the Fed started paring back bond purchases, before ending its bond purchases last month. To fight high inflation, 8.5% year-over-year in March 2022, Fed officials appear to be near agreement on a plan that would allow up to $95 billion in securities to mature every month without being replaced. The last time the Fed shrank its asset holdings, between late 2017 and mid-2019, the pace of balance sheet run-off was slower at about $50 billion a month. Fed Chair Powell has suggested that the pace of the Fed’s balance sheet run-off could be equivalent to a quarter-point rate hike. Recently, more central bankers have echoed support for a 50 basis point rate hike. The Fed hasn’t raised rates at consecutive policy meetings since 2006 and hasn’t raised rates by a half-point since 2000.

PREPA Debt Mediation Team… Three federal judges have been selected to mediate the restructuring of PREPA bonds. U.S. Bankruptcy Judge for the Southern District of New York Shelley Chapman will lead the mediation team. Bankruptcy Judge for the Southern District of New York Robert Drain and Bankruptcy Judge for the District of Delaware Brendan Shannon will serve as mediators. The mediation team will include the federal oversight board, Puerto Rico’s fiscal agency, bondholders, bond insurers, unions, fuel lenders and unsecured creditors. The mediation will cover more than $8 billion in legacy bond debt, over $700 million in unsecured fuel line loans, general unsecured claims, collective bargaining agreements, and PREPA’s pension plan. Island lawmakers that blocked the electric utility’s prior debt deal sought to be part of the mediation process, but were notably excluded by Judge Swain.

Federal Budget Boost For Government Issuers… A host of municipal bond issuers are benefactors of the White House Fiscal 23 budget agenda. President Biden’s $5.8 trillion federal spending blueprint provides $3.2 billion discretionary funding to states and locals. Schools stand to receive double the amounts enacted in the prior year federal budget. Affordable rental housing and home ownership funding programs see $1.9 billion in the pipeline, the highest funding level in nearly 15 years, along with other grants and incentives to advance development of affordable housing. The budget provides $50 billion to boost housing supply. Transportation projects, rails, ports and highways are significant beneficiaries as the budget rolls out of federal funding authorized by the Bipartisan Infrastructure Law. For Puerto Rico, the Biden budget seeks to raise federal medical assistance percentage to 76% from 55%, which could save the Island nearly $500 million, and allocates higher Medicaid and nutritional assistance funds relative to prior year. Political wrangling over spending priorities has resulted in several omnibus resolutions before Congress completes the federal appropriations process. While the White House budget is simply a request to Congress, which controls the government’s purse strings, it is a snapshot of federal administrations’ priorities.

Fitch Upbeat on Illinois Budget… “Short and long-term debt reduction and a balanced budget for the fourth year in row. We’ve achieved our state’s strongest fiscal position in generations,” Pritzker said on Saturday after the legislature approved a $46.5 billion Fiscal 23 spending plan that includes rainy day funding, supplemental pension funding and one-time tax relief. “The budget agreement in Illinois suggests the state is on track to implement credit- positive measures that rebuild fiscal resilience and reduce long-term liabilities including a meaningful deposit to the rainy day fund, addressing long-standing unpaid healthcare bills and chipping away at the pension liability,” a Fitch ratings analyst added “Continued operating performance improvement and movement towards structural balance, and maintaining a more normal fiscal decision-making process, could support a return to the state’s pre-pandemic rating or higher.”

Tax-Free Bonds More Resilient to Rising Rates… The value of tax-exemption grows during rising rate cycles. Yield changes of municipal bonds rise slower relative to taxable U.S. Treasury yield changes, meaning rising rates bring relatively smaller losses for municipal bondholders. Moreover, a strong economy, which is a precursor for rate hikes, boosts credit fundamentals of states and local governments, leading to a lower yield penalty for lower rated government bond issuers relative to comparable U.S. Treasuries. On a tax-adjusted basis, investment grade municipal bonds have outperformed Treasuries by 344 basis points annualized during the past two Fed rate-hiking cycles, while outperforming U.S. investment grade corporate bonds by 253 bps, PIMCO stated last month. Bond valuations change in response to market yields. Even though bond portfolios tend to post losses during rising rate cycles, municipal bonds continue paying the tax-free income and yield stated at purchase to investors with a long time horizon. For ‘buy-and-hold’ investors, rising rates are an opportunity to purchase bonds that offer higher tax- free income relative to older bonds that mature.

Compare 30-Year taxable U.S. Treasury yield 2.77% to 30-Year tax-exempt muni bond yield “AAA” 2.73%; “AA” 3.22%; “A” 3.42%; “BBB” 3.95%. For investors in the 35% tax-bracket, a 3.95% tax-exempt yield is equivalent to a 6% taxable yield. Top rated tax-free bonds yield 99% of comparable taxable U.S. Treasuries.