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Interest Rates

Rates-Driven Slide Masks a Strong Muni Credit Story

John Bonnell, CFA
Portfolio Manager and Managing Director
7 Jun 2022
4 min read

The Environment for Municipal Bonds Continues to Improve as Issuers Watch Revenues Surge

Municipalities Maintained Fiscal Strength During the Pandemic, Contrary to Expectations

During the recovery and expansion following the Great Financial Crisis, state and local governments raised revenue, controlled expenses and, unlike the federal government or, for that matter, corporations, did not take on excessive debt. As a result, municipalities recovered faster and stronger than most investors imagined possible. The combination of larger tax revenues, manageable debt loads and somewhat disciplined spending across most cities and counties help expand the largest rainy-day funds since the Global Financial Crisis.

State Tax Revenues Have Exceeded Expectations

Total State Revenue Growth (%) from 2019 to 2021

Tax Revenues Gains Were Broad-Based

We break down the surge in state and local government receipts into five categories:

  • Property Tax Revenue – Property tax receipts performed extremely well thanks to the low-rates-driven real estate boom that drove up assessed values of homes.
  • Real Estate Transaction Revenue – It should come as no surprise that with the surge in housing prices, the velocity at which real estate changed hands led to additional revenue from transaction fees. This not only benefited state and local governments but also other unexpected areas. For example, the New York MTA’s bonds heavily benefit from increases in the mortgage recording tax in NYC.
  • Sales Tax– States really benefited from a 2018 Supreme Court ruling, which paved the way for states to begin collecting sales taxes on online transactions. Between the ruling and the beginning of the pandemic more than 40 states enacted laws allowing for the collection of such revenues. These states have reaped billions of dollars in additional revenue as consumers continue to shift to online shopping.
  • Personal Income Tax Revenue – Surging income tax revenue was one area that was a big surprise for investors as expectations called for weakness surrounding the pandemic-inspired lockdowns. However, many firms and high-income earners were able to transition to a work-from-home environment which kept income tax collections strong throughout the pandemic.
  • Unprecedented Federal support – The exact numbers are hard to tabulate but as the Covid-19 pandemic swept through the nation, the Federal response was initially piecemeal with aid packages directed toward specific industries such as airlines. However, that support expanded to an enormous rescue package for a myriad of public-sector entities at the state and local level. All told it probably summed to more than $1 trillion of total support with most of it coming after revenues had bottomed and were already improving. As a result, there were massive swings in state budgets. For instance, California went from a projected $55B deficit to a $70B surplus.

Strong Tailwinds Have Continued

Since interest rates began rising in September 2021 the fiscal situation for municipalities has only continued to improve. Consumers that were able to transition to work-from-home situations found themselves with large pools of savings that they are anxious to spend, proving correct forecasts for continuing steady strength in tax revenues. And in fact, the three categories of tax revenues outlined above that led to strong revenue performance since the great financial crisis continue even now; for the month of January 2022 states reported a whopping 17% year-on-year increase in revenue growth.

Municipal bonds have been resilient through various interest rate cycles. Such buoyancy derives from the various levers issuers can pull on both the expense and revenue sides of the ledger to maintain their financial health. This cycle is no different and may be the strongest revenue cycles amidst a downturn. Municipal receipts are up sharply in much of the nation and are likely to remain strong along with pent-up consumer demand, the tight labor market, and the still-healthy housing market. Moreover, the current downward cycle was not sparked by a credit event or headline risk. In fact, we have neither.

Instead, the current slide in the municipal market seems to be the result of a negative feedback loop, induced by slide Treasury prices and corporate bonds in response to Fed tightening and generationally strong inflationary pressures. Leading up to this turn, municipal bonds saw the largest run of inflows the market has experienced in years, and it should come as no surprise that has been followed by one of the largest periods of outflows.

The impact of these mutual fund inflows and outflows has been amplified by the doubling of municipal bond mutual fund assets during the last seven to ten years. It is our opinion that investors who recognize the exaggerated swings in the municipal market may be able to seize higher coupon tax-free income emerging from the market carnage, especially compared to other fixed income asset classes.

Municipal Bonds’ Tax-Free Income Outshines Across Maturities


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