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From Stimulus Wishes to Tax Rates: Key Considerations for the Muni Market
- By Susan Courtney, Head of the Municipal Bond Team, and Garrett Falzone, Head of Municipal Bond Research
- December 2, 2020
As municipal bond investors look to 2021, they have some notable technical, fundamental, and policy aspects to consider. In the short term, a supportive technical backdrop featuring limited net issuance and continued inflows should remain intact through early 2021. However, that tailwind may be countered by ongoing concerns regarding the pandemic’s effect on municipal credit quality, especially as additional federal stimulus remains elusive. Furthermore, investors need to consider the policies that may affect the sector under a Biden administration with the control of the Senate still undecided, but the prospects of a blue wave watered down to the smallest of margins.1
A technical tailwind may not be associated with a year of record issuance, but the confluence of election uncertainty, historically low interest rates, the COVID pandemic, and a policy change pulled a significant amount of municipal tax-exempt and taxable issuance forward in 2020. Prior to the U.S. elections, a monthly record of $80 billion priced in October, nearly half of which was taxable, putting 2020 gross issuance of $463 billion on pace to be the largest on record. Driven by the collapse in Treasury yields and a provision in the Tax Cuts and Jobs Act (TCJA) that eliminated the ability of municipal entities to issue tax-exempt debt to advance refund outstanding bonds, taxable issuance accounted for more than a third of the total, making it the heaviest volume since 2010 when $150 billion was issued as part of the Build America Bonds program.
Figure 1: Record Issuance in 2020 Sets a Constructive Technical Backdrop in 2021
Despite 2020’s record issuance, the supply that was pulled forward sets the market up with a highly supportive backdrop heading into 2021 as net tax-exempt supply is expected to remain negative through the end of the year. Furthermore, estimates indicate -$50 billion in net supply in 2021, about seven times the negative net supply in 2020.2
On the demand side, an environment of stable-to-lower interest rates should support additional inflows from mutual funds, particularly as investors in states with higher personal income tax rates seek sources of tax-exempt income. The stable-rate backdrop may also incentivize investors to extend along a relatively steep muni yield curve, eventually leading to a potentially flatter curve going forward. Credit spreads should also experience some compression through the end of the year, particularly in sectors that bore the brunt of the spring’s spread widening, e.g. in the transportation and healthcare sectors.
For taxable munis, the combination of light supply and strong demand leaves this segment of the market positioned to perform well through the end of the year. A lighter corporate bond calendar should also encourage investors to focus on taxable munis, especially given their propensity for lower event risk and higher credit quality than investment-grade corporates. Non-U.S. investors may provide some additional demand given the huge swathes of high-quality, negative-yielding assets globally.
The Stimulus Question
While potential federal support for state and local municipalities remains in flux, most entities maintain the flexibility to address their virus-related budgetary strains, particularly as financial conditions appear to be stabilizing. Therefore, we don’t anticipate a wave of credit rating downgrades regardless of the fate of a federal support package.
As the stimulus drama has continued to play out at the federal level, most municipal issuers have taken the necessary steps to address their projected budget gaps—every state except Vermont has a balanced budget requirement—through a combination of expenditure cuts or increased revenue. However, signs of stability may be emerging as total tax receipts in September for most of the country were only 1.03% lower than the same period in 2019, which bodes well for 2021, particularly with the potential introduction of a vaccine later in the year.3 Tourism-sensitive states continue to report larger revenue declines, and, in general, we continue to believe that higher-quality credits across the municipal landscape will fare better as they adapt and address challenges that arise from the COVID crisis.
The Policy Front
A variety of policy initiatives could also affect the municipal bond market, with tax rates and infrastructure spending among the more frequently discussed topics. Potential hikes in personal federal income taxes remain possible under a Biden administration, but could pose a risk to the economic recovery and may face insurmountable resistance depending on the fate of the Senate. Yet, even without legislative action, investors are likely looking at higher federal tax rates in the future—thus higher tax-equivalent yields on tax-exempt municipal securities—as the personal income tax cuts under 2017’s TCJA are scheduled to sunset on December 31, 2025.
The reduction in the corporate income tax rate from 35% to 21% under the TCJA was permanent. But the Biden victory raises the question of whether there is appetite to raise the rate (even to something less than an increase to 28% as the Biden campaign proposed), which could boost muni demand from corporate investors, or if there is the potential to tie an increase in the corporate tax rate to an infrastructure spending program. The latter scenario is possible given the broad bipartisan support for an infrastructure program. The ongoing debate pertains to funding future infrastructure spending, e.g. the need for a program similar to the Build America Bonds initiative.
The effect of these potential policy changes is one of the key considerations for municipal bond investors going forward. When combined with municipalities’ flexibility to navigate a challenging, yet possibly stabilizing economic environment, and a beneficial technical tailwind, these considerations should provide the municipal bond market with consistent support into 2021.
This material reflects the views of the authors as of December 2, 2020 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.
1A January 5th Senatorial runoff in Georgia is set to determine control of the Senate.
2Estimates from J.P. Morgan
3Revenue levels provided by J.P. Morgan
Susan M. Courtney
Susan M. Courtney is a Managing Director and Head of PGIM Fixed Income's Municipal Bond Team. She is responsible for developing, directing, and executing investment strategy for all municipal bond assets, including the municipal bond mutual funds. Ms. Courtney joined the Firm in 2005 from GE Asset Management (GE), where she spent ten years as a municipal bond portfolio manager responsible for $4.7 billion in tax-exempt assets for insurance companies. Prior to her career at GE, Ms. Courtney was Assistant Vice President of the Global Power Group at Fitch Investors Services, Inc., and a Senior Analyst in the Unit Investment Trust Department of Dean Witter Reynolds. Ms. Courtney received a BA in Economics from Hartwick College and an MBA in Finance from Fordham University.
Garrett Falzone
Garrett Falzone is a Principal and Head of Municipal Bond Research for PGIM Fixed Income. Mr. Falzone covers a variety of sectors including higher education, senior living and project finance. Prior to joining the Firm in 2015, he established the municipal strategy team at Jefferies, LLC focusing upon both investment grade and high yield municipal sectors. Earlier, Mr. Falzone was employed at Lehman Brothers in the high yield municipal sales and trading and prior to Lehman oversaw all municipal high yield credit at BlackRock. Mr. Falzone earned a BS in Finance from Rider College and an MBA in Finance from New York University.
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