Trending
Written by: JB Golden | Advisor Asset Management
It’s hard not to be excited about the prospects for the municipal market in 2025. Yields sit at some of the highest levels in decades, the aggregate credit quality of the market remains high, and the days of supply-induced distortions seem to be behind us. On the one hand, the fundamentals of the market remain robust, offering a promising outlook. On the other hand, headline risks pose concerns and should be considered. This duality presents a unique scenario for investors as they navigate the year ahead, but ultimately likely represents a return to normalization and more room for opportunity. Frankly, it is refreshing to see the market begin to price in more risk.
Unless taxes and credit quality are of no concern, it is tough to envision a scenario when municipal bonds do not play a role in income generation for many years to come. That said, anecdotally, it seems as if the market may be beginning to price in more risk…which is not necessarily a bad thing. State and local governments have been the beneficiaries of federal stimulus packages, a low-interest-rate environment that was a boon for the municipal bond market, and an investor appetite that, at times, seemed insatiable. The influx of federal funds alleviated budgetary pressures and supported creditworthiness, while lower borrowing costs made it easier for municipalities to refinance debt and issue new debt at attractive rates. Demand remains strong and issuance, according to some analysts’ expectations, is headed for another record-setting year. Unfortunately, the era of low rates and federal aid are now behind us. Furthermore, the municipal bond market faces some unique headline risks heading into 2025.
Changes to tax policy, regulatory uncertainty and natural disasters have all been front and center for the municipal market a mere one month into the new year. On the tax policy front, the market will need to digest an effort to lock-in tax cuts set to sunset from the 2017 Tax Cuts and Jobs Act (TCJA) sometime in 2025. There seems a high likelihood that Republicans will have the support to pass tax legislation; however, the outlook remains somewhat murky due to several hurdles. Republicans do not hold the 60 seats needed to avoid a filibuster, which in turn means there is a need for bipartisan agreement, which is not likely. Republicans will likely need to use the budget reconciliation process to get any tax changes passed. In addition, there is almost certainly going to be pushback from deficit hawks given the significant revenue loss the tax policy would entail. Any talk of “tax cuts” is always going to catch the ear of the municipal market as it speaks directly to the value of any tax exemption. Ultimately, however, it could have less of an impact than evident at first blush. The 2017 TCJA is already “status quo” and represents the tax regime that has been in place now for some time. The wrinkle to the negotiations that could have broader implications for the municipal market revolves the state and local tax exemptions otherwise know as the SALT deduction. Under the current TCJA, households can deduct up to $10,000 in state and local taxes against their income at the federal level. Before the TCJA there was no cap on the amount of SALT deduction households could take and as such the TCJA represented a significant restriction. The SALT cap drove up the value of tax-exempt municipals, as an avenue to shield income from federal taxes, and high state-tax markets, such as New York and California, have traded at a premium ever since. The removal of the SALT cap is one of the few issues in Washington that could carry bipartisan support and if the cap is raised or eliminated it carries the potential to create volatility.
On the regulatory front, it has been quite an exciting first month for the incoming administration. Regardless of political leanings it is hard to argue that we have not seen an increase in regulatory uncertainty. The usually stuffy world of municipal bonds has not been immune. Just last week, the Trump Administration put a pause on all federal funding, including funding to state and local governments. The move was quickly blocked in federal courts and the current efforts are likely much more bark the bite. That said, state and local governments have a heavy reliance on federal funding and any uncertainty in that regard could have impacts. In addition to heightened uncertainty surrounding federal funding, the municipal market will likely have to grapple with continued conversations on how the current administration intends to pay for an extension of the 2017 TCJA. In mid-January, the U.S. House Committee on Ways and Means released a “wish list” of federal expenditures they would like to see eliminated to pay for the extension of the TCJA, which included conversations surrounding the elimination of the tax exemption for municipal bonds. Again, this seems highly unlikely to come to fruition and was included amongst a whole host of other recommendations — a good many of which are likely to be taken off the table. Nevertheless, the municipal market took notice. There can be no intelligent conversation on the municipal tax-exemption without an acknowledgement of the biggest beneficiaries. While the exemption does benefit wealthy and/or high tax-liability investors, the purpose of the exemption is to provide state and local governments with a low-cost source of capital. If you remove the exemption, the cost of capital for state and local governments is almost certainly going to increase and is likely much more significant than the cost savings to the federal government, defeating the purpose of removing the exemption in the first place. This is also the reason the proposal is likely to go nowhere, but the market should recognize that we are entering a period of heightened regulatory uncertainty.
Finally, it would be hard not to acknowledge what has already amounted to the worst natural disaster in U.S. history when discussing headline risk in the municipal market. Obviously, the loss of life and property due to the California wildfires should be the first and main consideration at this time. That said, the municipal market will almost certainly play a large role in the rebuilding efforts and has gotten a sharp reminder of the climate risk inherent in the market. It has been refreshing to see the orderly way in which the municipal market has digested the disaster. While spreads have widened, as they should, and bonds have been downgraded, as they should, even the most impacted credits still have a bid side and are changing hands. The scope of damage and the fact that we are talking about the world’s sixth largest economy and the nation’s largest state economy, likely means that there will be some impacts across the breadth of fixed income markets, not just municipals or California municipals. The expectations to date have been, and continue to be, concern over price volatility and downgrades as the biggest impacts. Market activity would also seem to confirm the concern is volatility not default. It is much too early to account for all the possible impacts, but the situation will likely be something that the market could be influenced by for quite some time.
Ultimately, investors should be aware of heighted risks in the municipal market heading into 2025 but, we believe, should also consider the glass-half-full side of the equation. We are now several years into a normalization process as it relates to interest rates. In our opinion, this normalization process is healthy long term, but should also likely include normalization as it relates to credit risk. The municipal market has always carried climate, headline, tax policy and regulatory risk. Whether these risks have been adequately priced into the market is another question. The question of the municipal tax exemption is a perfect example. While there has been little talk on the matter in the last 10 years, there was a time and a place — especially before the Great Financial Crisis — where it seemed to be discussed like clockwork every four years. Policy and regulatory risks are not new, the market has just ignored them in recent years, especially post-COVID. A market that is beginning to assess and price back in those risks is likely the healthier market long term. Moving back to a place where investors are adequately compensated for the risks that have always existed in the market is not necessarily a bad thing.
Related: Why Drawdown Funds Are Better Suited for Qualified Purchasers Than Evergreen and Interval Funds