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Week of 8/30/2021
Food Fight For Municipal Bonds… No Rush on Rate Hike, Powell… Illinois Yield Drop Makes History… Public Pensions’ Returns and Risks… More SALT Deductions?…
Food Fight For Municipal Bonds… “It’s absolute gold,” an institutional investor told WSJ that those who own tax-free bonds are unlikely to sell prized tax-free investments. “Everyone wants state and local government bonds,” the Wall Street Journal concluded. Finding muni bonds in the secondary market is challenging as trading activity has tumbled by 34%, with $1.43 trillion par amount of muni bonds traded so far this year, a 22-year low. On average, about $8.9 billion of municipal bonds are changing hands each day, the least since 2001. “Overall a lot more investors, whether they are participating in new issues or not, they are just holding on to their paper,” a portfolio manager said. “If you’re sitting on muni bonds that were issued three to five years ago I would ride it out,” another institutional investor noted. The surge in municipal bond prices is backed by President Biden’s promise to hike taxes on the wealthy. After riding out the COVID-19 health crisis with outperforming tax collection, credits of states and local governments are flying high on an influx of unprecedented federal aid. Low borrowing costs have made a big difference. State governments’ interest payments as a percent of debt outstanding fell to 3.4% in 2020 from 4.2% in 2010. Bidding competition for new issues has cut underwriting costs as top muni underwriters are willing to work for a pittance to sell state and local government paper as municipalities have shied away from the new bond issues. Oversubscribed retail orders have pulled yields lower than anticipated in the primary market. A recent New York City bond sale was 170% oversubscribed. Four times oversubscribed Santee Cooper’s $430 million new bonds, saw $1.8 billion worth of buy orders from 30 large institutions last week. Investors paid a premium upon strong market demand for tax-free electric utility revenue bonds rated Moody’s “A2” S&P “A” and Fitch “A” and secured a top yield of 2.16% for 4% coupon long term bonds. In September, investors will find only about $31.5 billion of new municipal bonds in the primary market, not enough to reinvest $35 billion from tax-free interest and principal receipts. An investor who bought the bonds reflected in the S&P Municipal Bond Index 10 years ago and reinvested the interest he earned would have seen his investment grow 50%, per S&P Dow Jones Indices. Bondholders who got into the market years ago are sitting on hefty returns, have no reason to sell, and grab opportunities to buy more tax-free bonds.
No Rush on Rate Hike, Powell… Fed Chair Powell hinted that the Federal Reserve could begin to reduce its bond purchase this year and the economy has ‘much ground to cover’ before conditions for the first rate hike since 2018 could be met. “Even today, with overall gross domestic product and consumption spending more than fully recovered, services spending remains about 7% below trend. Total employment is now 6 million below its February 2020 level, and 5 million of that shortfall is in the still-depressed service sector.” Chairman Powell added “It is worth noting that, since the 1990s, inflation in many advanced economies has run somewhat below 2% even in good times due to sustained disinflationary forces, including technology, globalization and perhaps demographic factors, as well as a stronger and more successful commitment by central banks to maintain price stability.” Chair Powell noted that higher inflation readings are likely temporary, as he highlighted the prevalence of global disinflationary forces over the past quarter century.
Illinois Yield Drop Makes History… Illinois’ new tax-exempt bonds issued last week fetched record low yields, as investors sought as little as 69 basis points over top rated benchmarks for Illinois bonds maturing in 2034. Credit spread or yield penalty is down steeply from a March sale when similar-dated bonds fetched 1.19% more than top rated benchmarks. Overall interest costs of 1.31% for $130 million tax-free bonds sold last week is favorable for the lowest rated U.S. state which has recently won accolades from rating agencies. Lured by billions of dollars of revenue outperformance and federal aid, eleven underwriters competed for the Illinois bonds. Illinois Director of Capital Markets stated “The State of Illinois received very strong bids from a large number of firms in this competitive sale that produced the lowest credit spreads the state has seen in many years.”
Public Pensions’ Returns and Risks… Returns between 25% to 30% for many public pension systems has broadly boosted pension assets. Public pension funds, which count on annual gains to cover benefits promised to retirees, have increased purchases of riskier investments including high yield bonds to counter low interest rates and slow global economic growth. The scale of unfunded pension liabilities varies dramatically across the United States. Illinois’ pension liabilities are four times its own source revenue, making its public pension system the riskiest in the nation. Large unfunded pension liabilities have spiked Connecticut’s leverage to highest among U.S. states. Michigan cut pension risks for state employee plans, but teacher benefits and many local governments’ plans are underfunded. Strong legal protections, such as the ‘California Rule’ developed over decades, through many state Supreme Court decisions, effectively limit reforms to future employees, unless offset by a comparable new advantage. Pension risks such as large unfunded liabilities, rising contribution requirements and significant investment volatility, are integral to state and local government credit quality. Gov. J.B. Pritzker’s 2019 Pension Asset Value and Transfer Taskforce was a bold initiative that sought to contribute state real estate towards Illinois’ public pensions as a supplement to cash funding. Raising taxes, cutting services and issuing debt are tools for tackling pension underfunding. States with low pension risks boast “AAA” credits.
More SALT Deductions?… High tax states are crafting workarounds to expand state and local tax (SALT) deductions from itemized individual federal tax returns. A $10,000 cap on SALT deductions enacted in 2017 became controversial because of its high price tag. Manhattan residents, who pay the highest SALT, $18,543 average, led a trend of emigration from high tax areas. Workarounds that allow certain pass-through businesses to pay state income taxes at the entity level and then claim a credit on their state return, instead of having income pass to individual owners for taxation, are gaining traction. Illinois became the latest to enact the tax maneuver and New York could follow suit. Neighboring New Jersey and Connecticut too have allowed a type of workaround. Democrats in Congress are now debating expanding the SALT deduction. A $3.5 trillion budget resolution adopted in both the House and Senate calls for increasing or doing away with the SALT cap. Soon after Labor Day, lawmakers will consider tax reform legislation.
Compare 30-Year taxable U.S. Treasury yield 1.91% to 30-Year tax-exempt muni bond yield “AAA” 1.56%; “AA” 1.83%; “A” 2.05%; “BBB” 2.12%. For investors in the 35% tax-bracket, a 2.1% tax-exempt yield is equivalent to a 3.2% taxable yield. Top rated tax-free bonds yield 82% of comparable taxable U.S. Treasuries.
If you have any questions or desire updated information contact your GMS Account Executive.