What's driving munis in 2021?

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July 1, 2021


With changes to the US tax code on the horizon, businesses and workers could soon find themselves in a different financial environment. But what would that mean for municipal bonds?

Since the Biden administration took the reins, many have been expecting changes to the current tax code; something on which it campaigned.1 This could include raising the corporate tax rate, the marginal income tax rate, and boosting the top capital gains tax rate, among other proposals. Part of the reason for these sweeping tax reforms would be to partially fund President Biden’s Build Back Better initiative, which comprises a newly agreed upon US$1.2 trillion infrastructure plan, the American Jobs Plan (AJP) and a second US$1 trillion package, focused on social measures like welfare programs and healthcare, called the American Families Plan (AFP).

While the tax overhaul could materially affect the financial profile of both corporations and individuals alike, the investment world has its eyes on what this could mean for the municipal bond market.

Demand drivers

As part of the AJP, President Biden proposed raising the corporate tax rate from 21% to 28%. Prior to 2018, the corporate tax rate sat at a steady 35% for 25 years until the preceding administration kickstarted the Tax Cuts and Jobs Act (TCJA).2 Accordingly US banks, among other corporations, reduced their state and local government bond holdings by billions of dollars as there was less incentive to own tax-exempt fixed income investments. However, prospects for higher corporate taxes could conversely prompt corporate demand for tax-exempts with a new administration in place.

“This would raise the intrinsic value of tax-free municipal bonds for banks and insurance companies, or that institutional buyer base, which really haven’t been involved from a demand perspective for the past few years,” says Sherri Tilley, BNY Mellon Investment Management municipal bond analyst.

“As expected, a higher corporate tax rate could raise the value of a municipal bond coupon to these entities because they weren’t encouraged to look at munis when their tax liability was reduced on the back end of the TCJA.”

Similarly, as part of the AJP, the new administration proposed raising the marginal income tax rate for wealthy individuals who make over US$400,000 a year, from its current 37% to 39.6%. According to the White House, this would help raise US$1.5 trillion over a decade from the implementation date.3 Such an income tax rate increase for this demographic has not been seen since before the TCJA, similar to a corporate tax hike proposed on corporate entities.4 As with prospects for increased interest from the institutional buyer base, this could bode well for retail investor demand of tax-exempt municipal bonds.

“From a technicals and valuation perspective, that should be supportive for municipal bond demand from a retail investor standpoint. So demand from individuals should get a boost to the extent that we’re looking at higher tax rate increases,” Tilley says.

There is also talk of raising the capital gains tax rate from 20% to 39.6%.5 This could further help boost demand for tax-free fixed income.

Shifting supply

In regard to supply, Tilley is keeping her eye on the possible reinstatement of tax-exempt advance refunding. Advance refunding is when issuers take the funds from a new bond issuance to pay off a prior issue’s debt. When refunding was restricted for tax-exempt bonds after the TCJA, taxable bond issuance grew more than fourfold and tax-exempt issuance fell sharply.6 But if reinstated for tax-exempt bonds, taxable municipal supply could be impacted if issuers choose to capitalize on the legislation.

“This would be a positive technical driver for taxable munis given their scarcity of supply in the sense that issuers can shift from taxable muni supply back to tax-exempt muni supply,” Tilley says.

Conversely, taxable municipal bond supply could see a boost as there is currently bi-partisan legislative support for a federally subsidized direct- pay bond financing vehicle similar to the Build America Bond program. That program played a vital role financing infrastructure after the Global Financial Crisis, according to Dan Rabasco, head of municipal bonds at BNY Mellon Investment Management.

Questioning quality?

Federal stimulus including the US$350bn that was allocated to states from the American Rescue Plan Act of 2021 will be constructive for municipal bond credit fundamentals and could bolster the quality of state and local government debt, according to Rabasco. Even before the advent of this stimulus, municipal budgets actually performed better than initially expected and benefitted from stronger economic growth. In aggregate, state tax revenue growth has been reflective of improving fundamentals.

Additionally, Rabasco says that states and local governments actually received more than US$350bn since the federal government also allocated US$129bn for K-12 education, US$40bn for higher education, US$30bn for mass transit, and US$8bn for airports, which are mostly managed by state and local governments. This should continue to benefit municipal credit fundamentals by helping to stabilize state finances as well as covering pandemic costs and replenishing lost revenue of the most severely impacted sectors, he says. With the latest infrastructure bill proposal, there is also the potential for an additional US$49bn for public transit, US$109bn for roads, and US$25bn for airports.

“There are going to be legs to municipal bond credit fundamentals for quite some time,” he says. “It’s likely that we’ll see a trend of credit ratings upgrades as a result.”

Lately, municipal bond credit spreads have tightened, making a case for high yield municipal bond exposure. Although spreads have somewhat recovered from highs during the pandemic—and some may worry that this is already priced in—they still have room to go and are likely to continue following a positive trend, according to Rabasco. This view is helped by the fact that high yield municipal bond defaults have been on the decline.7

While federal aid has undoubtedly been beneficial for some of the most pained sectors, they are also beginning to rebound due to a range of other factors. This includes the high rate of vaccinations throughout states, as well as a rebound in national economic activity, which has been particularly beneficial for the transportation sector, according to Rabasco.

“The prospect of higher taxes fueling demand, together with the improving fundamental picture, has staying power,” Rabasco says. “We continue to see constructive forces supporting our bond market. That’s where our conviction comes from, especially for those revenue sectors we favor that were previously under stress and continue to rebound,” he concludes.

1 Tax Policy Center: Biden follows through on his campaign promise of big tax hikes on US corporations. March 31, 2021.

2 Municipalbonds.com: What it means when the biggest banks reduce their muni debt holdings. July 5, 2018.

3 CNBC: Biden wants to raise $1.5 trillion by taxing the rich. Here’s how? April 29, 2021.

4 Tax Policy Center: Historical Highest Marginal Income Tax Rates. February 20, 2020.

5 CNBC: Wealthy investors may be in for a capital gains tax hike. Here’s how they’ll manage. May 4, 2021.

6 Advisor Perspectives: The municipal market may be on the brink of a dramatic shift. May 24, 2021.


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