30 Year High Demand for Municipals

The first half of 2021 has seen an increased demand for investment grade municipal bonds, outpacing their taxable counterparts. Expectations for higher taxes in 2022 that could be included in a potential stimulus package have kept demand high, while muni net supply was constrained the last few months (1).

Figure 1. Estimated net flows into municipal bond funds, first half of year. Graph from Refinitiv Lipper, Tax-Increase Talk Prompts Wealthy to Splurge on Muni Bonds, (Karen Langley, July 19, 2021).

With new tax plans proposed by the Biden administration, wealthy Americans have fled to municipal bonds at a record level. Municipal bonds typically offer interest payments that are exempt from federal taxation. Local municipalities, institutions, and state governments issue municipal bonds to raise money for various projects, such as schools, bridges, roads, and hospitals. Even more, many municipal bonds also bypass state and local tax impositions. As a result, high earners in the upper tax brackets may be eager to reduce their tax bill by investing in government projects. The current top tax bracket is 37%, but may be increasing under the Biden administration as early as 2022, as capital gains tax rates are also slated to increase.

Muni bonds, already known for relatively low default risk, scored a credit boost in 2021 as state and local governments received billions in federal stimulus money (2).

As the coronavirus pandemic shut down large portions of the U.S. economy, cities and states suddenly expected that revenue shortfalls would lead to serious budget problems. In many municipalities, the fiscal damage turned out to be less severe than anticipated. Federal aid for households and businesses supported consumer spending, and the economy picked up more quickly than expected (3). According to a Hilltop Securities report,

At least $350 billion of the Rescue Plan’s dollars will flow to state and local governments. A total of about $650 billion spread across different spending line-items will also significantly support credit quality across many public finance sectors. This capital boost could put the U.S. public finance on the brink of a golden age because of the opportunities that currently exists for state and local government leaders, especially if infrastructure stimulus follows later this year. Municipal bond credit will be lifted across almost every sector (4).

As congress continues to negotiate on the bi-partisan infrastructure bill, the municipal market is both directly and indirectly affected. Muni bonds have been attractive to many investors who seek exposure to quality debt related to renewable energy, clean water, and transportation.

Figure 2. Infrastructure – Key Provisions from the White House (March, $bn over 10 years) and the Bipartisan Framework (June, $bn over five years). Graph from The White House, U.S. Senate, Committee for a Responsible Federal Budget, Barclays Research, What’s Next for Municipal Bonds After a Strong First Half of the Year? (Albert Jalso, July 15, 2021)

There are many key developments within the infrastructure bill that boasts many opportunities within the municipal market. Topping the list is the federal investment in electric vehicle related projects, such as charging stations. As such, many states and municipalities are tasked with supporting these projects and must continue to maintain them through debt issuances.

Nonetheless, the municipal market may be on the brink of a drastic shift. Under the Tax Cuts and Jobs Act, tax-exempt issuance fell sharply because the TCJA prohibited advance refunding of tax-exempt debt with tax-exempt issuance. Taxable issuance rose more than four-fold as supply shifted from the tax-exempt market to the taxable market (5). The administration is expected to restore tax-exempt advance refunding, causing a shift back to tax-exempt munis.

Figure 3. Issuance of Taxable vs. Tax-Exempt Municipal Bonds from 2015-2021 YTD. Graph from Loomis Sayles, The Municipal Market May Be on the Brink of a Dramatic Shift, (Jim Grabovac, May 24, 2021).

Additionally, regardless if the global minimum tax rate becomes effective, the Biden administration is looking to increase the tax rate for corporations as well. An often-overlooked fact is that corporate buyers account for approximately 20% of the municipal market buyer base, the tax increase may increase their demand for tax-exempt investments (6).

1) Advisor Perspectives, July 15, 2021

2) CNBC, June 30, 2021

3) The Wall Street Journal, July 19, 2021

4) Hilltop Securities, March 19, 2021

5) Land Scape, May 24, 2021

6) Parametric Portfolio, April 29, 2021