GSTAX – Tax-Free Income in a Low-Income Desert
The global search for income continues as the Federal Reserve and global central banks work to keep rates low and contain inflation expectations. Municipal bonds stand out as they do from time to time due to the unique nature of the municipal bond market when combining the expected multi-trillion dollar Covid-19 relief packages (yes I believe that is the first time I have ever written multi-trillion) to support the underlying credits and the expected increases in tax rates that at least pretend to try and pay for all that relief.
Bloomberg Barclays Municipal Bond Index- An unmanaged index considered representative of the tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.
Bloomberg Barclays High Yield Muni Index- An unmanaged index considered representative of noninvestment- grade bonds.
THE TECHNICAL NATURE OF THE MUNICIPAL BOND MARKET
The municipal bond market remains widely held by retail participants. Nearly 2/3 of the municipal market is owned by retail buyers either directly or through managed products. Rarely are they bought in large corporate trusts or “automatic” accounts like 401ks.
In addition, the municipal bond market sits at the intersection of finance and politics. This can lead to retail buyers allowing headlines, especially political headlines, to drive their investment decisions. Short-term over-reactions, which we’ve seen plenty of lately, have led to outsized outflows, creating opportunities for investors who can see through the short-term noise. In Q1 2020, money poured out of the municipal bond market (over $12 billion in outflows in March and April) due to the toxic mix of pandemic fear and a heated presidential election. We expect we are now in the initial stages of the reversal of those flows back into the municipal bond market.
A TRILLION HERE, A TRILLION THERE, PRETTY SOON WE’RE TALKING REAL MONEY!
In December, Congress passed a $900 billion relief package signed by former President Trump, on top of the unprecedented $2 trillion CARES Act stimulus package in Spring 2020. Not to be outdone, the newly installed Democrat-controlled Congress is poised to pass another $1.9 trillion, on top of the $2.9 trillion. State and local governments have received about $280 billion in federal aid thus far. Roughly $120 billion was earmarked in the second relief package, and at least $300 billion of the new package is set to be targeted to state and local governments, which will indirectly help shore up the overall creditworthiness of the municipal bond market. Overall default rates have remained relatively low, though they ticked up slightly in 2020 ($2 billion in 2020 vs. $1.5 billion in 2019). There will certainly be more defaults in 2021, but we expect overall default rates to remain only slightly elevated above the long-run default rate. Recovery rates also continue to be greater than 60% in the municipal bond market due to legal covenants and the prevalence of mortgages in lesser-rated bonds.
Much of the financial aid has been, and will continue to be, targeted toward the sectors most under stress – education, healthcare and transportation. Most of the stress regarding project financings has hit those deals either in construction or those that had recently come online. These projects have wobbled, and it is unclear how much, if any, of these newer projects will be supported in the Covid-19 relief packages. Projects already up and running were able to receive direct support more quickly through the Paycheck Protection Program (PPP) and other similar programs and have generally held up better.
UP, UP AND AWAY – TAX RATES
We are sorry to report that the new tax plans currently floating around the halls of Washington, D.C. and state capitals are expected to result in higher combined state and federal tax rates of up to 58% in NY, 60% in NJ, and 62% in CA – the highest rates in more than 30 years. There will undoubtedly be an increase in the upper brackets’ marginal tax rates, and the payroll tax will most certainly be extended to capture taxes on income beyond the current $142,800 income cap. We expect these tax changes to increase the value of the tax-exempt income stream provided by municipal bonds over the coming years.
THE FUNDAMENTALS OF THE MUNICIPAL BOND MARKET AND THE VALUE OF ACTIVE MANAGEMENT
The $3.8 trillion municipal bond market has more than 50,000 unique issuers and more than one million separate securities. Each state has different rules, regulations and tax rates that can impact the credit quality and liquidity of a bond. How should one manage all of that? We believe this market creates a real opportunity for active portfolio managers. Our expertise and due diligence policies allow us to analyze all segments of the market and uncover bonds that provide investors with a better risk/reward ratio, leading to long-term performance. We tend to find the best value in the higher-yielding and smaller corners of the muni market, so that is where we spend most of our time and energy. We look forward to putting our expertise to work for you.