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Midterm Elections: What Do They Mean for the Muni Bond Market?

Key Points
  • Infrastructure spending is one of the few issues that could generate compromise in the new Congress next year. If spending rises, it could result in greater municipal bond issuance.

  • However, we still expect demand for tax exempt income to be strong in 2019, which could offset a potential supply increase.

  • While credit conditions for some states may be strained if economic activity slows, we don’t expect significant ratings downgrades in the near term.

Though the midterm election votes are still being counted, two things are certain: The Democrats will take control of the House of Representatives and the Republicans will increase their control of the Senate.

For the municipal bond market, the results have the potential to increase issuance of munis and affect the financial flexibility of some issuers. With each party controlling a chamber of Congress, we don’t expect any significant legislation—including tax cuts—to pass during the next two years. However, one issue that could garner compromise is infrastructure spending. This could result in increased municipal bond issuance.

Greater issuance of municipal bonds without an increase in demand should result in muni yields increasing more than Treasury or corporate bond yields of comparable maturities and credit ratings. However, demand for tax-advantaged income should remain strong, which would temper a potential rise in muni yields relative to Treasuries.

We expect Congress to take a more favorable view of munis

With the Democrats gaining control of the House of Representatives, U.S. Rep. Richard Neal (D-Mass.) is set to take over for U.S. Rep. Kevin Brady (R-Texas) as chairman of the House Ways and Means committee. While on the surface this may not seem like it would affect municipal bonds, the Ways and Means committee is the chief tax-writing committee in Congress.

As chairman, Neal will have the ability to influence the proposals that are put before the committee, and we expect he will be more supportive of municipal finance than his predecessor, based on his past positions. For example, Neal led an unsuccessful effort in 2013 to reinstate a popular type of taxable municipal bond—Build America Bonds (BABs)—to help spur infrastructure investments.

Taxes are less likely to change

Prior to the midterm elections, President Donald Trump and other Republicans said they were working on a 10% tax cut for the middle class, but that is now far less likely due to a divided Congress. Because the two parties have struggled to find areas of bipartisan consensus recently, we think it will result in political gridlock going forward. As such, we don’t expect any major changes to the 2017 tax law revisions.

For the muni market this should mean that munis will continue to be a relatively attractive option for high-income earners. As can be seen in the chart below, munis currently yield more than corporate bonds after taxes at the 24%-and-above tax brackets.

Munis yield more than corporate bonds for high-income earners

As of November 9, 2018, after-tax yields on corporate bonds for investors in the 24%, 32%, 35% and 37% were 3%, 2.5%, 2.4% and 2.1%, respectively. After-tax yield on the Bloomberg Barclays Municipal Bond Index was 3.1%.

Source: Bloomberg Barclays Corporate Bond Index and Bloomberg Barclays Municipal Bond Index, as of 11/9/18.

Note: Corporate bonds assume an additional 5% state income tax and 3.8% Affordable Care Act tax for the 32% and above brackets.

Because we don’t expect any major changes to tax laws, we likewise expect no change to the deduction of state and local taxes (SALT). This will continue to affect filers in high-tax states like New York and California, where the SALT deduction was claimed by approximately one-third of residents and averaged well over the $10,000 cap[1]. Partly due to the cap on the SALT deduction, we recommend that only muni investors in New York and California consider a portfolio of all in-state munis. Investors in all other states should consider diversifying nationally.

An infrastructure package may be an area for agreement

Following the election, both President Trump and House Minority Leader Nancy Pelosi (D-Calif.) have touted infrastructure development as an area on which the two parties could reach a compromise. The need for new and improved infrastructure—things like bridges, roads and power supplies— is enormous,. The American Society of Civil Engineers gave America’s infrastructure a D+ in its 2017 Infrastructure Report Card, and warned that poor infrastructure was harming the nation’s ability to compete globally. While both parties generally agree on the need for better infrastructure, we expect the main sticking point will be how to fund the package, assuming the issue gains bipartisan traction.

Trump introduced a plan in February 2018 that would have required state and local governments to pay for 85% of the costs, with the remaining amount to be covered by $200 billion of federal money. The plan never gained any real traction. However, if a similar new plan were introduced, in which states and the federal government shared costs, it could result in a new type of municipal bond. We would expect that new muni bond to be similar to the BABs that were championed previously by Neal. We acknowledge there are many steps between proposing a plan and it coming to fruition, but if a new type of muni bond is created that is similar to the BABs, we expect it would result in greater issuance of munis. Increased issuance should result in higher muni yields relative to Treasuries and corporate bonds of similar maturities and ratings. However, it could also lead to increased financial strain on issuers if they borrow additional money.

Some state measures could limit financial flexibility in the future

Control of the House and Senate garnered most of the attention, but there were state ballot measures that also could have an impact on the muni market. Voters in six states—Arizona, Connecticut, Florida, Indiana, Maryland and North Carolina—passed measures that could reduce their state’s flexibility to raise revenues if needed. This is a credit-rating negative, according to Moody’s Investors Service.

We don’t think these six states will have their credit ratings downgraded in the immediate future solely due to these ballot measures. However, they could face strain if the local economy slows. We would also caution investors against overreacting, because as the table below illustrates, all the states that passed measures that restrict financial flexibility, except for Connecticut, have ratings in the top two rungs—Aaa/Aa by Moody’s or AAA/AA by Standard & Poor’s.

Six states passed measures that will limit their ability to raise revenues if needed

​   ​

Source: Moody’s Investors Services and S&P, as of 11/7/18. S&P ratings as of 11/13/18.

Note: The S&P rating for Arizona and Indiana is the indicated credit rating (ICR)

The state of Illinois should benefit from the gubernatorial outcome

The state of Illinois was downgraded to one notch above junk by both Moody’s and S&P last summer, primarily due to the inability of the Republican governor and Democrat-controlled legislature to reach a compromise on the budget. Now that one party (Democrats) will control both the Illinois State Legislature and the governor’s mansion, reaching compromise on a budget should be easier (note that we don’t intend to say that Democratic or Republican control is better).

What to do now

We don’t expect the credit ratings for the vast majority of municipal issuers or yields for municipal bonds to be immediately affected by the results of the election. We currently believe an average duration between five and eight years, and an average credit quality in the AA range, offers the best balance of risk and reward. For help in selecting the right municipal bond investments for your portfolio, we encourage you to reach out to one of our fixed income specialists.

¹ Source: Tax Policy Center, as of October 12, 2017, for tax year 2015

 

 

What You Can Do Next

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
  • Explore Schwab’s views on additional fixed income topics in Bond Insights.
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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

The Bloomberg Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds.

The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar (USD)-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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