Investors have baked in the idea that taxes will rise under the Biden administration, but bipartisan infrastructure talks have called that assumption into question in the near term.
The proposed bipartisan Senate infrastructure package does not include higher taxes for either individuals or corporations — one of the larger reasons for the muni rally this year.
“For the first half of the year as investors have been buying munis, the assumption was that taxes would go up under a Biden administration,” Barclays strategist Mikhail Foux said. “What happened this year was that investors were looking ahead.”
In January and February, there was no stimulus package yet and COVID-19 was still a real threat, he noted. There were no tangible tax reform or infrastructure proposals on paper.
“Nevertheless we established all sorts of records in the hope that those things would happen later this year,” Foux said. “The last couple of trading sessions, there has been some pressure. Treasuries rallied last week and munis sold off. Maybe it was the increase in supply, perhaps it was skepticism about tax reform, and people put it all together and maybe are becoming a bit more cautious.”
The Biden administration has now twice walked away from negotiations with Republicans. The White House was initially engaged in talks with a faction of Republicans represented by Sen. Shelley Moore Capito of West Virginia, before abandoning those efforts in favor of working with a bipartisan group of moderates that included Republican Sen. Rob Portman of Ohio and Democrat Sen. Kyrsten Sinema of Arizona.
But White House negotiators appeared to throw in the towel on those talks earlier this week, as the parties failed to reach agreement on how to pay for a proposed $579 billion for surface transportation. Biden has pledged not to raise taxes on households earning $400,000 or less annually, and Republicans have signaled skittishness at the idea of largely erasing the 2017 tax cuts enacted under Donald Trump.
This leaves the door open for Democrats to use the budget reconciliation process to force a bill through the Senate without Republican support. That maneuver imposes certain time limitations on tax provisions, namely imposing on them a 10-year expenditure window but with it also more of a likelihood of higher tax rates via Democratic proposals.
Muni advocates in Washington are still not completely convinced that chances for a bipartisan deal are dead.
“I still am not convinced that this is going to end up being a totally Democratic-alone infrastructure bill given the margins in the Senate with [West Virginia Democrat Joe] Manchin and Sinema,” said Charles Samuels, who represents the National Association of Health & Educational Facilities Finance Authorities. “It could go any direction, but I am still thinking that maybe there will be this ‘smaller bill’ — smaller only relatively speaking — that is core transportation which will be bipartisan. Then there will be a big House-driven Democratic bill that will pass the House and not the Senate and end up being a political talking point in the next election.”
Muni lobbying efforts are generally optimistic that strong demand for municipals would come as a result of the infrastructure bill becoming a vehicle for several tax changes, including reinstatement of tax-exempt advance refunding and the creation of a new direct-pay bond program similar to Build America Bonds.
But those proposals don’t appear to be part of the compromise talks.
Therefore many participants say it is too soon to put much stock in proposals from Washington impacting the market in the near-term. They still anticipate higher taxes in some form; it is the timing that is difficult to predict.
“With this net negative supply and heightened demand for munis, we think there are still enough investors that are betting on higher taxes,” said Jeff Lipton, managing director of credit research at Oppenheimer Inc.
Market technicals, with the most important being scarcity of paper, have largely been driving current rates low and keeping them there, Foux, Lipton and other sources said.
Fund flows are massive, particularly high-yield, credit quality is objectively improving due to a faster COVID recovery boosted by federal aid, and investors are flush with cash needing to be put to work.
And while most participants said they expect tax increases, how they are implemented and which investors they target will be important for the market to consider.
“Keep in mind that most individuals who buy munis tend to be in a sub-30% tax bracket, so going to 39.6% from 37%, it might not have as much of an impact on retail demand,” Lipton said.
A meaningful lift in the corporate tax rate from 21% to 28% as the president has proposed would elevate institutional interest.
“Even if it were to rise to 25%, we think that would elevate institutional interest,” Lipton said. “There would likely be more participation from P&C insurance companies and bank investors.”
Technicals would argue for continued outperformance.
“Last week we did see upward pressure on yields and ratios post-FOMC, but we still view munis as rich relative to U.S. Treasuries, and valuations are still somewhat frothy,” Lipton said. “It is the scarcity value, the tax-efficiency-driven demand, the above-average credit quality, and portfolio diversification attributes that make munis a compelling asset class. We would expect to see continued strong performance from munis throughout the summer months.”
If taxes don’t actually rise, then munis could underperform. It is generally accepted that when taxes are higher or lower it affects demand.
“It’s just way too early and these 'bipartisan' plans do not have payfors,” said Matt Fabian, partner at Municipal Market Analytics. “The real ones suggested, such as the gas tax and electric vehicle taxes are just straw men. Until they have a genuine agreement, I’m not going to accept it as a credible bipartisan plan.
“It skews the odds back to a fully Democratic plan and if it goes through reconciliation, which in that case it has to be paid for.”
If Biden’s tax increases look improbable in the next two years, some investors may be less interested in the asset class, sources said.
“But to say that we’ll sell off, or that ratios are going to return to 1992 levels, that just isn’t plausible,” Fabian said. “There are so many strengths locked into our market at this point. The scarcity factor has trumped everything else. You cannot understate the problem with that scarcity and how that puts other risks to the backburner.”
Regardless of the proposals working their way through Washington, most participants say the fundamentals are too strong for any of them to dramatically alter the demand component for the asset class.
“I don’t think people will stop putting money into munis," Foux said. "That doesn’t stop.”
