Week of 6/20/2022

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Municipal Bonds Sell-Off…Municipal Funds See Large Outflows…Steep Rate Hikes to Fight High Inflation… Recession Risks…Higher State Revenue…Slower State Spending…Puerto Rico Eyes COFINA Refinancing… Sales Tax Reform Push…

Municipal Bonds Sell-Off… Bondholders shunned the riskiest corners of the municipal bond market, as recession fears loom. Longer dated high yield bonds have lost over 17% with inflation at a forty-year high, while shorter dated securities lost less than 2%. Actively traded high yield Puerto Rico bonds lost 14.6% this year, more than the 13% decline for the riskiest state and local debt, per Barclays Bloomberg data. This is arguably the worst showing for the Island’s bonds since the second half of 2017, when Hurricane Maria slammed into Puerto Rico. A 75 basis fed funds rate hike has ravaged global financial markets, and municipal bonds are caught in the storm. Credit quality of states and local governments has nothing to do with the surge in yields and volatility. States and local government credits boast of solid outperformance and are riding high on a spate of credit upgrades. Top-rated tax-free bond yields rose about 14 to 19 basis points upon expectations of steep rate hikes ahead, while ‘BBB’ tax-free yields rose about 50 basis points since last week. Tax-free bonds are performing the worst since March-20 COVID- 19 rout, with over 10% year-to-date losses in municipal benchmarks.

Municipal Funds See Large Outflows… Investors pulled about $5.6 billion from municipal-bond mutual funds during the week ended June 15, 2022 per Refinitiv Lipper US Fund Flows. The exodus is the third-biggest on record. Investors have yanked out cash 17 out of the past 18 weeks. Majority of the outflows were from long term bond funds, followed by high yield bond funds. When investors pull out of muni bond funds billions of dollars worth of municipal bonds are sold at rock-bottom prices. For the first time since late May-22, long term tax-free bond yields topped 100% of taxable Treasury yields. Long -term ‘Buy-and-Hold’ investors, who are comfortable with the credit story and high market volatility, at times take advantage of higher yield to add to their tax-free bond portfolio at better prices.

Steep Rate Hikes to Fight High Inflation… Committing to lower inflation, the Federal Reserve hiked its policy rate by 75 basis points last week to 1.6%, the largest rate hike since 1994. The move upended the Fed’s May estimate of a 50 basis point rate hike in June. “Since then, inflation has again surprised to the upside,” Fed Chair Powell added, “either a 50-basis-point or a 75-basis-point increase seems most likely at our next meeting.” The fed -funds rate could be 3.4% at year-end per central banker estimates, about 1.50% higher than projected in March-22. The Fed sees slower rate hikes in 2023, followed by a rate cut in 2024. Fed officials forecast that inflation could run at 5.2% this year, before falling to 2.6% next year and 2.2% in 2024, down from 8.6% recently. “My guess is that you will see further increases in projected inflation, projected unemployment, project interest rates,” former Treasury Secretary Lawrence Summers added that the 75 basis point rate hike was a desirable move. Inflation risks are tilted to the upside, and the Fed said ongoing rate hikes, along with continuing to significantly reduce the size of the central bank balance sheet play an important role.

Recession Risks… The New York Fed predicts an economic contraction this year and next, and the Atlanta Fed’s GDB model signals zero economic growth in the second quarter. The U.S. economy contracted at a 1.5% annualized rate in the first quarter of 2022. Meanwhile, Federal Reserve Bank of St. Louis President James Bullard, who expects economic expansion to continue this year as the U.S. labor market remains robust, said, “Risks remain substantial and stem from uncertainty around the Russia-Ukraine war and the possibility of a sharp slowdown in China.” Financial conditions have tightened considerably with mortgage rates exceeding 6%. The Fed predicts 1.7% economic growth this year and next, followed by 1.9% growth in 2024 as unemployment could rise to 4.1% by then. Fed Chair Powell stated, “We’re trying to achieve 2% inflation consistent with a strong labor market.” A slower housing market, disappointing retail sales, and a contraction in the Philadelphia Fed’s manufacturing index have come with high inflation and the Fed’s policy response. Cutting its growth estimates for this year, Goldman Sachs economists said “We now see recession risk as higher and more front-loaded” as it expects the Fed to respond forcefully to high inflation.

Higher State Revenue… State revenue, $357 billion in Q1-22, is 21% higher than a year ago per U.S. Census bureau. California tops U.S. states, with tax revenue 38% higher than prior quarter. U.S. State general obligation bonds, $323 billion outstanding, enjoy the security of broad-based state taxing power, and carry a strong presence in the $4 trillion municipal bond market.

Slower State Spending… Governors of U.S. states want to spend 4.2% more in Fiscal 23, down significantly less than a 13.6% annual spending growth rate in Fiscal 22. State revenue is expected to grow at a slower pace of 3.2% in Fiscal 23, down from a 16.5% growth in tax collections in Fiscal 22. 30 U.S. states are proposing net decreases in taxes and fees, while only three are proposing net increases. National Association of State Budget Officers reported “State revenue forecasters are watching closely for warning signs about the economy as the Federal Reserve tries to bring inflation under control, the Russia-Ukraine conflict continues to put upward pressure on gas prices, and labor shortages and supply chain issues continue to present challenges for states and businesses.”

Puerto Rico Eyes COFINA Refinancing… The Island is eager to capitalize on its exit from bankruptcy, which has cleared uncertainty. Its resurgent economy, booming tax collections suggest that the Island has come a long way from hurricane ravages of 2017-2018. When the sales tax secured COFINA Bonds were restructured, the Island faced a long, murky road in the Title III court. That is no longer the case today, although Puerto Rico is still an unrated bond issuer. Last week, Island officials assembled a team to evaluate a potential refinancing of restructured COFINA bonds over the next year. Any restructuring must create debt service savings, and not extend maturities, an Island official stated, and it must be approved by the federal oversight board. COFINA 5% long term bonds are trading near par reflecting gains for bondholders who received such bonds in 2019 at about 97 cents on the dollar.

Sales Tax Reform Push… E-commerce, a $1 trillion sector, knows no borders. State boundaries mean little for fast- growing remote online sellers, that do not want to riddled by varying sales tax regimes across U.S. states. 45 U.S. states and the District of Columbia impose sales tax on remote sellers based on economic presence not physical presence. In 2021, 33 U.S. states collected $23 billion of sales tax, up from $3.2 billion in 2018. Compliance with tax regulations across state borders is burdensome for online sellers. Uniform sales tax practices are sought by 24 U.S. states, who have signed a ‘Streamlined Sales Tax Agreement’ to reduce complexity. Federal guidelines could also be effective for uniformity. But, state and federal taxing powers have clear boundaries. Only a third of jurisdictions exercise sales tax authority. More uniform sales tax could be a win-win for the e-commerce sector and U.S. states.

Compare 30-Year taxable U.S. Treasury yield 3.34% to 30-Year tax-exempt muni bond yield “AAA” 3.42%; “AA” 4.04%; “A” 4.44%; “BBB” 4.45%. For investors in the 35% tax-bracket, a 4.45% tax- exempt yield is equivalent to a 6.85% taxable yield. Top rated tax-free bonds yield 102% of comparable taxable U.S. Treasuries.