Week of 7/11/2022

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Municipal Bonds’ Record Losses Retreat… July Rate Hike…Public Pension Assets Fall… States’ Debt Service Manageable…Illinois Audit Timeline Improves…California’s Record Surplus…Senior Housing Sector Occupancy Grows…

Municipal Bonds’ Record Losses Retreat… July is poised to be the first month of 2022 with positive returns for the muni bond market. Municipal bond indices have gained over 1% so far this month. Muni bonds have lost close to 8% this year. Municipal bond yields have risen roughly 170 basis points this year. Bank of America strategists said last week that they are seeing retail investors show a more ‘persistent interest in adding’ to muni bond portfolios. “This is the environment we have been waiting for, i.e., a more stabilized macro rates environment in which muni supply/demand factors will be rationalized,” Bofa strategists forecast ‘strong performance’ for muni bonds in the second half of 2022. Along similar lines, Barclays strategists noted there is potential for a year-end rally although near-term conditions in the muni market could be choppy. Expecting to see muni bond gains in the second half of this year, Barclays added “The hole is likely too deep to climb all the way out of, but we see tax-exempts returning 2-3% for the rest of 2022.” Charles Schwab strategists, who expect muni bond losses to taper down by year- end, stated, “The story is that credit quality is very strong.” Municipal bond funds, institutional buyers of state and local government bonds, are seeing fewer outflows. As municipal bond valuations have dropped this year, the outlook for future total returns is much brighter.

July Rate Hike… A strong jobs report sets the stage for a 75 basis point rate hike at the Federal Reserve’s July 26-27 meeting. At the Fed’s June meeting, officials weighed either a 50 basis point or 75 basis point rate hike in July. At least three Fed officials, Federal Governor Christopher Waller, St. Louis Fed President James Bullard and Atlanta Fed chief Raphael Bostic favor a 75 basis point rate hike in July. St. Louis Fed President James Bullard said “it would make a lot of sense to go with 75 [basis points] at this juncture” to raise rates to around 3.5% by the end of this year. Eyeing a lower 50 basis point rate hike in September, Waller explained, “If inflation just doesn’t seem to be coming down, we have to do more.” Over the past few weeks, many commodity prices including oil, copper, and food that are central to inflation measures have slumped dramatically but could go higher again amid volatility. The consumer-price index has been running higher, climbing 8.6% in May—a new 40-year high. Aggressive Fed actions, declining commodity prices and weaker consumer spending have driven down expectations of future inflation implied by yields on inflation-adjusted Treasuries. Traders assign near certain odds of a 75 basis point rate hike in July, followed by 50 basis points in September.

Public Pension Assets Drop… U.S. state retirement plans have enough assets to cover 70% of promised benefits, down from 81% a quarter back per Wilshire Advisors. The drop comes from lower investment returns. The funded ratio has fallen to pre-COVID levels. Meanwhile, pension liability valuations are lower because a higher interest rate factor is used to calculate the present value of future liabilities. High inflation is likely to drive up pension wage bills, and increase future pension obligations. Many states including Connecticut, Michigan, New Jersey and Illinois have made supplemental pension contributions recently, a positive step.

States’ Debt Service Manageable… States’ debt service spending is small compared to other fixed costs, such as pensions and Medicaid. Aggregate state debt service was only 3.3% of state spending last year, the least in over a decade per S&P. However, there are outliers. Connecticut’s debt service accounts for almost 14% of state spending, the highest among U.S. states, followed by Hawaii and New Jersey which spend over 10%. Notably, state debt service spending in relation to government expenses declined last year amid a state spending boom fueled by massive federal aid. State debt levels tend to rise during economic expansions, and vice versa. In 2021, aggregate state tax-supported debt rose 4%, the fastest in the last five years, however, lower than 6% debt growth in 2015 and 8% in 2011. Lower cost of borrowing led states to amass more debt in 2021. That is set to change this year.

Illinois Audit Timeline Improves… Last week, Illinois published its Fiscal 2021 audit, almost a year after the fiscal year closed. Although tardy, the audit timeline has improved from last year. Despite the lag, Illinois did beat a handful of U.S. states, an improvement considering it has been the near last in financial reporting in past years. Ongoing implementation of an Enterprise Resource Planning system is expected to eventually result in more-timely financial reporting. The state ended fiscal 2022 with just $1.8 billion in bills down from $3 billion a year ago. State Comptroller noted, “Today’s fiscal report means that Illinois is better poised to face upcoming challenges to state finances as the nation experiences record levels of inflation.” Illinois’ two largest revenue sources, income tax and sales tax depend on economic cycles.

California’s Record Surplus… With a record high $97 billion budget surplus or money left after Fiscal 22 spending commitments, California enacted a $308 billion spending plan for Fiscal 23, which continues a remarkable turnaround for the nation’s most populous state. Just two years ago, Golden State raised taxes and slashed spending in fear of a $54 billion budget deficit from pandemic woes. Instead, California’s revenues soared on the back of a roaring stock market that boosted the ranks of the wealthy who pay higher tax rates than other states. The top 1% of California earners account for roughly half of all the state’s income tax collections. The result: a $97 billion budget surplus. Warning signs abound as Golden State revenue could drop significantly for several years during a recession.

U.S. Senior Occupancy Grows… For the fourth quarter in a row, occupancy at senior living facilities trended higher. Senior housing facilities are running at roughly 81% occupancy, per a recent trade survey. Seniors housing facilities, perhaps the first to see the pandemic, saw droves of residents flee during the pandemic. Rampant vaccinations have boosted occupancy. Moreover, new construction has ebbed to the lowest since 2015. A lid on new construction, from higher interest rates and rising material prices, suggests existing housing for the elderly could see more demand.

Compare 30-Year taxable U.S. Treasury yield 3.22% to 30-Year tax-exempt muni bond yield “AAA” 3.08%; “AA” 3.69%; “A” 4.00%; “BBB” 4.07%. For investors in the 35% tax-bracket, a 4% tax- exempt yield is equivalent to a 6.15% taxable yield. Top rated tax-free bonds yield 96% of comparable taxable U.S. Treasuries.