Week of 4/4/2022

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Taxes and More Taxes…‘Constructive’ Outlook on Munis, Morgan Stanley…Public Pensions Brace For Inflation…Illinois Pension Buy-Out Plan…New Jersey Wins Another Rating Upgrade…

Taxes, and More Taxes… Higher inflation is effectively a tax, as Americans in all walks of life end up paying more tax dollars as prices of homes, utilities and autos grow. Along with the toll of inflation, President Biden’s Fiscal 23 budget outlines politically contentious tax hikes. President Biden’s tax agenda seeks $2.5 trillion over ten years from tax hikes. Raising the top income tax rate to 39.6% from 37% could raise $187 billion. Under the Tax Cuts and Jobs Act of 2017, the current 37% top rate is scheduled to expire and return to 39.6% in 2026. Biden’s proposal would accelerate the sunsetting of the 37% rate. The top rate would not only rise, but it would also apply to more taxpayers because the bill proposes to lower income thresholds to qualify for the top rate. Those making more than $1 million could see capital gains taxed at top income tax rate of 39.6% (43.4% including the 3.8% net investment income tax versus 23.8% now). Tax benefits during wealth transfer are also under the axe. Corporate taxes would surge to 28% from 21%. A ‘Billionaire’s Minimum Income Tax’ that seeks to tax unrealized gains for those earning more than $100 million is unprecedented and could garner $360 billion over a decade. The billionaire’s tax plan may not be as consequential for municipal bond investors, but a millionaire’s tax has been adopted in six U.S. states including California, New York, New Jersey and Connecticut. New taxes usually start out applying to a few, and then spread to millions. Such was the case with the Alternative Minimum Tax created in 1969 as a flat 10% tax on the uber-rich that has grown to cover tens of millions in the middle class. Earlier, wealth tax plans from Sens. Elizabeth Warren (D-Mass.), Bernie Sanders (D-VT) and Ron Wyden (D-Ore.) were rejected by moderates. Democrats are trying to revive the House-approved Build Back Better agenda that was scuttled by centrists such as Senator Joe Manchin (D- W. Va) and Kyrsten Sinema (D-AZ) who said they would only support legislation that reduced the deficit, a step to fight inflation. While the plan is stated to cut the federal deficit by $1 trillion, it faces political resistance in a midterm election year, particularly when inflation is high. To improve tax compliance, $14 billion is allocated to the IRS, a sharp increase from prior year. Tax bills are taking up a larger wallet-share, and the need for tax-sheltered investments is growing.

‘Constructive’ Outlook on Munis, Morgan Stanley… Higher municipal bond yields are beginning to draw investor attention. Top-rated long-term tax-free bonds fetch 106% of the yield of comparable taxable Treasuries, suggesting favorable prices of municipal bonds. The Muni-Treasury ratio was as low as 67% in 2021. Valuations of muni bonds have prompted Morgan Stanley strategists to have a ‘constructive outlook’ on municipal bonds. While investors may be ‘uncomfortable’ buying municipal bonds in the near term, tax-free bonds could end up outperforming other fixed income alternatives over a six to 12-month period, Morgan Stanley said. A Citigroup analyst is monitoring fund outflows for any sign of a turnaround. “Unfortunately what happens when you have a selloff when rates rise, fund outflows just surge. When fund outflows surge, you have a big drop in demand and that impacts muni performance.” Municipal bond funds have seen cash outflows of over $20 billion this year. The spectre of higher taxes could be a catalyst for municipal bond demand, although President Biden’s recent plan is far from the finish line. Driven by higher inflation and interest rates, municipal bonds posted a 6.4% loss in the first quarter, the worst returns in four decades.

Public Pensions Brace For Inflation… A dimmer prognosis for investment returns comes at a time when cost-of- living adjustments (COLAs) will ramp up pension dollars owed to retirees of state and local governments. U.S. public pensions investment returns are trending lower towards a 3% loss forecast for the year ending on June 30, 2022 per a recent Moodys composite of market indices. To cope with a tight labor market, pressure is building to reopen defined benefit plans to new hires, grant new COLAs or rescind prior pension cuts. Over the past decade, substantial pension reforms including benefit cuts and higher employee contributions were undertaken to restrain pension liability growth. A few states are finding that pension reforms went too far and are trying to undo some pension cuts. States and local government’s exposure to investment volatility has never been higher. Anticipated losses come after public pensions saw stellar investment returns in prior year. Political momentum to upend some pension reforms is growing. Adding pension benefits, which is often easier than cutting back, could have long term implications for states and local governments.

Illinois Pension Buy-Out Plan… $1 billion of new state bonds to buy out future benefits promised to retirees with a large one-time payment have been approved by the Illinois legislature. Illinois’ pension buy outs, which started in 2018, have cut IL pension liability by $1.4 billion per state administration. The state recorded strong investment returns last year that helped trim the gap between pension assets and liabilities. Pritzker also wants to make $500 million in supplemental pension contributions and to pay down more bills. Illinois Constitution bars lowering promised benefits to retirees. The state’s $139.9 billion of unfunded pension liabilities have cast a long shadow on the finances of the lowest rated U.S. state. The non-partisan Commission on Government Forecasting and Accountability stated “The state’s fiscal condition and economic environment improved enough that Illinois received upgrades from the rating agencies for the first time in two decades. Despite this good news, the state still has many issues to deal with before its fiscal house is in order.”

New Jersey Wins Another Rating Upgrade… For the first time since 2005, S&P Global Ratings has raised its rating on New Jersey’s general obligation bonds. “The upgrade reflects what we view as material improvement in the state’s structural deficit and near-term liquidity, with recent surplus revenues being used to promote what we view as longer-term financial stability and an improved commitment to prefunding liabilities, although credit pressures remain,” S&P stated. S&P’s favorable rating action echoes Moody’s rating upgrade last month. “This is not only welcome news for the state and our taxpayers, it reaffirms that the steps we have been taking, up to and including the governor’s newly proposed budget, are the right ones,” NJ state Treasurer added “In reaching this decision, S&P noted our efforts to reduce debt by roughly 10%, along with our prudent revenue estimates that will better position us to weather any future economic slowdowns or downturns.” Gov. Phil Murphy stated “We are turning the page on decades of downgrades and doing what others had only talked about for years delivering on our commitment to fully fund the pension system, saving for a rainy day, and paying down debt proving that investing in New Jersey and its people can go hand-in-hand with fiscal responsibility.”

Compare 30-Year taxable U.S. Treasury yield 2.45% to 30-Year tax-exempt muni bond yield “AAA” 2.60%; “AA” 2.99%; “A” 3.26%; “BBB” 3.81%. For investors in the 35% tax-bracket, a 3.83% tax-exempt yield is equivalent to a 5.8% taxable yield. Top rated tax-free bonds yield 106% of comparable taxable U.S. Treasuries.