Municipal credit revenue continues to improve. This week it was reported that US state and local government tax revenue rose almost 7% in the second quarter, from a year earlier. This marks seven quarters in a row of growth (following five quarters of decline). More importantly, tax revenue now slightly exceeds the peak of revenue set in 2008, before the financial crisis set in.
This is important on two counts. First, it blunts the Meredith Whitney arguments that led to the bond-fund sell-off last winter. But also, it reinforces the argument about the quality of municipal credits. Many state and local municipal entities enjoy captive audiences – for water, sewer, transportation, etc. They performed in this recession like they have in others, by tightening belts, cutting costs, and raising fees where necessary. And this has been a big contributor to the curing of the muni market since last winter.
The White House proposals are keeping muni rates high. The Obama administration’s Jobs Bill has proposed imposing a tax on individuals or couples above certain income thresholds, to essentially eliminate the tax advantage enjoyed between the 28% and 35% tax bracket. This 7% tax would translate into roughly a 35-basis-point tax on muni yields (4-4.5% range). We do not think there is much chance of this proposal being enacted – certainly not to include existing municipal bonds. However, the uncertainty is helping to contribute to tax-exempt bond yields which are much higher than they would be without it. In some cases, taxable BABs (Build America Bonds) yields are only marginally higher than the tax-exempt form of the very same credit. The market has started to see cross-over buyers respond to this anomaly.
As we head into the last quarter of the year we expect to see municipal supply pick up. It downshifted greatly early in the year, due to the high interest rates fostered by the Whitney meltdown. With lower nominal rates, visible supply is starting to pick up. But the December/January reinvestment period should also be vigorous – especially given the volatility of the equity market. That should mean most of the reinvestment goes back into the muni market.
And after much consternation on all sides, we do not expect the Administration proposals with regard to tax-free bonds to pass. This should also mean that the muni market will return to more normalized pricing levels relative to Treasuries.
Thanks to our friends at Cumberland Advisors.