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Week of 8/8/2022
Demand for Municipal Bonds… Governments Not Immune to High Inflation… U.S. State Revenue Outlook Wanes…Federal Funding Boost For Hospitals…Google Real Estate Buyout Positive for Chicago, Illinois…Insured Municipal Bonds Scarce…
Demand For Municipal Bonds… Investors added about $1.1 billion to municipal-bond mutual funds during the week ended Wednesday per Refinitiv Lipper US Fund Flows data. The gain follows the prior week’s $236 million inflow and marks only the fifth weekly inflow since February. Most of the cash was for long-term tax-free investments. “Large fund outflows have stopped (there was actually a sizable inflow this week), supply remains subdued (the past month was the lowest July’s issuance number in more than two decades), 30-day visible supply is still well below average, and, of course, investors will benefit from $40bn+ in redemptions in August, not counting $12bn in coupons,” Barclays strategists explained. Last week, bellwether 10-year Treasury yields dipped to 2.5%, down from a high of 3.47% in June. Bellwether 10-year U.S Treasury yields will likely fall to 2% in six to 12 months, Bank of America forecasts. “Underlying this forecast is the belief that the market has not priced in the risk of a hard landing; although, at this point, the prevailing view on the economy is still a mild recession,” BofA strategists added “Technically speaking, we are already in a mild recession due to the negative GDP prints for the last two consecutive quarters. Still, a strong jobs market has distinguished it from a normal recession. We expect the high grade muni rally to remain strong in August and credit spreads to be stable-to-slightly narrower.” Demand for municipal bonds tends to be higher when recession looms as investors seek the safety of government payors.
Governments Not Immune to High Inflation… Faced with higher costs for operations, wages, services, and capital improvements, states and local governments are keeping an eye on high inflation. Political pressures to reduce or suspend some state taxes have increased with high inflation. Many U.S. states are on gas tax holidays and a few such as Illinois have suspended grocery taxes for a year. Lower consumption is a key concern when consumers get less for their money due to high prices. Sales tax revenue collected in April is lower than a year ago in twenty-six U.S. states, and sixteen other reported slower sales tax growth per the National Conference of State Legislatures. Reflected in two straight quarters of falling U.S. GDP, high inflation will likely lead to lower consumption. “If you don’t see inflation start to come down over the latter part of the year and you see more aggressive types of tightening being necessary to restore price stability than in the short term, that can be a headwind,” a Federal Reserve Bank of Kansas City economist opined that U.S. states will likely see growth slow in the coming fiscal year. To what extent can sales tax be a hedge against rising prices is not a clear-cut answer.
U.S. State Revenue Outlook Wanes… Both New York and California warn that future state revenue is likely to underperform. California’s Legislative Analyst Office assigns 70% odds that Golden State tax revenues will underperform the $210 billion budget enacted in May-22. “Like the rest of the country, New York State is facing substantial headwinds with a changing national economy, and our latest update to the enacted budget financial plan reflects that,” New York State Governor Kathy Hochul warned last week that the Empire State’s primary revenue source, income tax could fall $3.1 billion in Fiscal 24. New York State budget gaps could grow from $310 million in Fiscal 24 to $6.2 billion by 2027, although budget surpluses are likely to continue in the current fiscal year. Early signs of future tax collections come from income tax withholding which declines when Americans expect lower capital gains and income. Some U.S. states including Illinois, Michigan and New Jersey have seen a steep drop in income tax withholding payments, Brookings Urban Institute reports. Wage growth has not kept up with record high inflation. 13% of Americans have spent more than they earn in the last six months, per a LendingTree survey. There is significant uncertainty about how much U.S. states will collect in taxes in Fiscal 23. The U.S. state sector made financial progress in recent years. A slowing economy is a dampener on state revenue outlook.
Federal Funding Boost For Hospitals… Hospitals will see a 4.3% increase in Medicare payments received from the federal government. It’s the highest increase over the last two decades and is driven partly by hospitals’ higher wage bills. The hospital sector continues to face lower margins. Hospital margins had begun to stabilize in the second half of 2021 when patient volumes climbed with growing vaccinations. That changed this year when inflation soared. In 2022, patient volumes were not an issue, but high inflation led to six straight months of negative margins a Kaufman Hall National Hospital Flash report noted. “Improvement in operating margins from reduced levels will require hospitals to make transformational changes to the business model” over the long term, while in the near- to mid-term they will manage “cost pressures through a combination of rate hikes and relentless, ongoing cost-cutting and productivity improvements” Fitch noted. Amid heightened regulatory scrutiny, hospitals are seeing a wave of consolidation driven by economies of scale.
Google Buyout Positive for Illinois, Chicago… Thompson Center, a marquee state government office building in downtown Chicago will be sold to Google. The $105 billion deal is “a massive win for the city of Chicago and for Illinois taxpayers,” Governor Pritzker said. The state will save nearly $1 billion over 30 years by consolidating office space and lowering operating cost. The vote of confidence from Google comes amid departures of Boeing and Citadel from the Windy City. Mayor Lightfoot echoed that Google’s expansion brings “one of the largest economic development opportunities in decades”. For over two decades, Illinois had been trying to sell the Thompson Center, as its upkeep had become a financial burden. The deal is a victory for Governor Pritzker’s agenda of monetizing underutilized real estate to boost state finances.
Insured Municipal Bonds Scarce… Fewer municipal bonds were insured this year relative to last year. The decline relates to the overall drop in primary market volume. As such, insurance concentration has trended higher post-COVID-19. Close to 9% of municipal bonds issued in the primary market this year carry bond insurance, up from around 6% in 2019. The volume of bond insurance policies written in the secondary market have grown. Institutional investors have increasingly turned to bond insurance amid volatile market conditions. Assured Guaranty writes bond insurance on about 54% of newly insured municipal bonds, followed by Build America Mutual. Assured Guaranty noted “We believe that two important factors have helped to amplify the use of bond insurance: wider investor awareness that insurance offers safety from many potential consequences of volatile economic conditions and a larger number of issuers recognizing the cost-effectiveness of bond insurance.”
Compare 30-Year taxable U.S. Treasury yield 3.03% to 30-Year tax-exempt muni bond yield “AAA” 2.90%; “AA” 3.48%; “A” 3.88%; “BBB” 3.85%. For investors in the 35% tax-bracket, a 3.8% tax-exempt yield is equivalent to a 5.8% taxable yield. Top rated long-term tax-free bonds yield 96% of comparable taxable U.S. Treasuries.