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The latest agreed fiscal package, worth US$892bn, will impact how states and local governments fare over the next few months but it’s not the sole factor in their fiscal stability, according to Tilley.
“Whether or not the aid is sufficient is mitigated by existing resources and reserves from previously instituted spending cuts and Coronavirus Aid, Relief, and Economic Security (CARES) Act funding. “
For local governments, a primary revenue source for cities and counties is property tax. Given the strength of the housing market in the current environment, we expect property tax collections to remain resilient.”
The housing market, which fuels property tax revenue, has held up better than some expected over the past year. In fact, US home prices climbed a record 3.1% in the third quarter of 2020, lifting them 7.8% over the same period in 2019.1 Additionally, November 2020 saw homebuilding surge 12.8% on a yearon- year basis.2
Despite this, Tilley and the Mellon team will still be closely watching the effects of the latest fiscal package as an ongoing recession would drag on states’ own funding, such as tax revenues. Sales tax revenue, which suffered at the height of the pandemic due to reduced consumer spending, does appear to have recovered.3 With more stimulus checks on the way, consumer spending could be further bolstered as the new US$900bn fiscal package includes US$600 per person for millions of Americans and unemployment benefits of up to US$300 per week for 11 weeks through March 14.4
Additionally, the pandemic’s impact on income tax has not been extraordinarily severe, according to Tilley. Employment data reflects high-income workers, who pay more in taxes, have been less affected than low-income workers.5 Therefore, income tax generation from high income workers has been largely uninterrupted, according to Tilley.
Rainy days savings
Also bolstering many states and local governments are the vestiges of rainy-day funds, or emergency reserves, saved during times of economic prosperity to combat future recessionary conditions, Tilley explains. Despite COVID-19 and subsequent lockdowns, in some states these reserves were generally supportive and are partially responsible for a less severe fiscal impact than initially expected, Tilley says.
According to stress testing analysis conducted in 2019 by Moody’s Analytics, at least 28 states were prepared for a moderate recession, while another 12 were at near-level preparedness.
In the near term, rainy-day funds and the ability for some states to raise revenue/reduce expenses should help buoy fiscal health. However, over the long term, “Federal support via direct aid or new stimulus programs will be key to preserving current credit ratings,” Tilley says.
Not all states and municipalities are created equal, she adds. Certain areas of the country are experiencing disproportionate impacts from the pandemic.
“Tourism-dependent economies, such as Hawaii, Florida and Las Vegas have been largely impacted. Energy-dependent economies, such as Alaska, Louisiana, Texas, Oklahoma and North Dakota have also been affected due to decreased commodity prices,” Tilley says.
According to Tilley, any change to the federal tax code under the incoming Biden administration will be important for the municipal bond market. Some examples Biden proposed ahead of the fall election include restoring the top tax rate on ordinary income to 39.6% from its current 37% and raising corporate tax rates to 28% from 21%.6
Tilley says: “The implementation of higher marginal and corporate tax rates would enhance the value for tax-exempt municipals.” Federal tax policy changes affect individual state policies as they tend to conform to the federal code for consistency in tax administration, she adds, noting that if federal tax levels are raised, it could be a tailwind for municipal bond demand. This is due to the tax-exempt status on interest income in some municipal bond issues.
If income taxes are raised, she expects retail investor demand for municipal bonds to strengthen. More importantly, she says a change in corporate tax policy could further drive demand.
“Interest from banks and insurance companies has recently waned with lower corporate tax rates under the Tax Cuts and Jobs Act (TCJA). A higher tax liability for financial institutions would also increase municipal demand from a buyer base previously on the side lines, further supporting an already positive supply/demand dynamic,” she says.
On the supply side, Tilley expects issuance to be greater influenced by the level of interest rates rather than tax proposals.
“To the extent rates remain low enough to drive savings from refunding activity, that could lead to higher issuance,” she says. “Furthermore, the appetite for issuers to fund new projects and take on additional debt expense will coincide with their fiscal and overall economic health.”
Even without change to the current federal tax code, municipal bonds will remain attractive from a yield and credit-quality standpoint, Tilley says. According to Moody’s Investment Services, the average 10-year cumulative default rate (to end of 2019) for investment grade municipal bonds is 0.10%, while for global investment-grade corporate bonds, it’s 2.25%. Similarly, for high yield municipal bonds it’s 7.29% compared to 28.69% for global high yield corporates.7 For additional context, muni defaults in 2020 totalled US$2.2bn, and while it was 61% more than 2019, it was still lower than both 2018 and 2017 default totals.8
As for recent returns, in December 2020, the Bloomberg Barclays Municipal Bond Index gained 50 basis points (bps), while the Bloomberg Barclays US Corporate Index, representative of US investment grade corporate bonds, was down 28bps.9 This means, going into 2021, municipal bonds have the support of lower historic default rates and recently favorable performance, in comparison to their corporate counterparts.
Market technicals are the prime reason she expects the asset class to outperform in the year ahead.
“Any further economic rebound will drive more favorable credit conditions overall which should in turn fuel valuations, including yield premiums toward more normalized levels, providing a boost to returns,” she says.
Signs are pointing to a similar backdrop seen in 2019 and 2020, where the expectation for 2021 is netnegative supply for tax-exempt municipal bonds. “In an environment with consistent demand, this should be a tailwind for performance next year,” she concludes.
1 Federal Housing Finance Agency: US House Prices rose 3.1 percent in the third quarter; up 7.8 percent over the last year. November 24, 2020.
2 CNBC: U.S. housing starts, building permits power ahead in November. December 17, 2020.
3 US News: States See Modest Growth in October but Suffer Bigger Employment Losses. December 16, 2020.
4 Washington Post: Senate majority leader announces approximately $900 billion deal on emergency relief package. December 20, 2020.
5 Center on Budget and Policy Priorities: Tracking the COVID-19 Recession’s Effects on Food, Housing, and Employment Hardships. December 18, 2020.
6 CNBC: Here’s what’s ahead for President-elect Biden’s tax plan. November 10, 2020.
7 Moody’s Investor Service: US Municipal Bond Defaults and Recoveries. 1970-2019. Average 10-Year Cumulative Default Rate for the Period 2010-2019. July 15, 2020.
8 Bank of Merrill Lynch: Municipal Weekly. Accessed January 2021.
9 Bloomberg: Bloomberg Barclays Indices. December 21, 2020.
All investments involve some level of risk, including loss of principal. Certain investments have specific or unique risks. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines.
The amount of public information available about municipal securities is generally less than that for corporate equities or bonds. Legislative changes, state and local economic and business developments, may adversely affect the yield and/or value of municipal securities. Other factors include the general conditions of the municipal securities market, the size of the particular offering, maturity of the obligation, and the rating of the issue. Income for national municipal funds may be subject to state and local taxes. Income may be subject to state and local taxes for out-ofstate residents. Some income may be subject to the federal alternative minimum tax for certain investors. Capital gains, if any, are taxable.
Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others.
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