Due to the dynamic nature of financial markets, they are susceptible to an array of factors from around the world, and municipal debt markets aren’t immune to these events. While 2019 witnessed strong U.S. economic growth due to strong consumer spending and historic low unemployment rates, the year 2020 started with tumultuousness in U.S.-Iran relations, presidential impeachment, and global unrest due to Coronavirus.
So far, these events have yet to show an impact on U.S. financial markets and the Federal Reserve is projected to have a stable outlook on interest rates. In addition, contrary to popular opinion, the Fed decided to cut rates in 2019, which was paired with the global demand for yield and credit spread exposure, enabling more local governments to save on net interest costs by issuing taxable bonds to pre-refund outstanding tax-exempt debt.
In 2019, municipal debt funds witnessed continued inflow of funds from investors and the issuance of new municipal debt registered $421 billion due to the lower interest rate environment.
In this article, we will discuss the 2020 outlook for municipal debt markets from both the issuance and investor standpoints.
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The Impact of the 2020 U.S. election on Municipal Debt Markets
The U.S. elections and a potential change in the political party occupying the White House can certainly shift the direction of various policies, which will have a significant impact on municipal debt markets.
First would be the national federal income tax policy and second would be the shift in U.S. monetary policy based on U.S. economic conditions. In 2018-2019, financial gurus and investors had projected a change in the direction of interest rates in the U.S. from previous years. As economic conditions were getting better, financial markets started talking about future interest rate hikes to prevent the U.S. economy from overheating. All financial indicators, including consumer spending, unemployment numbers, and strong overall GDP growth, hinted toward a Federal Reserve rate hike environment; however, in 2019, the Fed changed its course on interest rate hikes to cutting short-term interest rates by a total of 75 bps (basis points), and it is currently projecting no changes in 2020.
On the income tax proposition, John V. Miller – Head of Nuveen Municipals – stated that, “An emphasis on higher taxes can be a tougher political sell, but new revenues must be identified to fund the Democrats’ expensive health care, education, childcare, and affordable housing policy proposals. Higher wealth and income taxes generally support demand for tax-exempt municipal paper, and could contribute to positive fund flows, especially in states that provide a state tax exemption for residents. Should President Trump win re-election, federal tax policies are likely to remain largely unchanged. Regardless of the outcome, we expect the tax environment to continue to support a strong demand for tax-exempt income and municipal bonds.”
A Surge in Taxable Municipal Debt Issuance Likely to Continue into 2020
As tax laws were amended, municipal issuers are no longer able to advance refund their previously issued tax-exempt debt with new tax-exempt debt. The low interest rate environment in 2019 presented enough savings for issuers to advance refund their tax-free debt with taxable debt. This was particularly beneficial for high-grade issuers that were able to capitalize on low interest rates for taxable debt, advance refunding the tax-free debt at sizable savings. In 2019, approximately $67 billion of taxable municipal debt was issued.
As mentioned earlier, because the Fed is projected to and has signaled holding interest rates low, the taxable municipal debt issuance is likely to hold strong and continue into 2020.
It’s also important to note that tax-free municipal debt provides greater benefit to individuals in higher income tax brackets. Beyond 2020, interest rates are likely to stay lower for longer, so combining some longer-term bonds that offer higher yields with shorter-term bonds will provide greater flexibility for investors. Investors who are not in the top federal tax bracket may achieve higher after-tax yields by combining short-term taxable bonds with longer-term munis.
Don’t forget to check out this article to know more about municipal debt taxation.
Geopolitical Tension and Municipal Debt in 2020
Investors regard municipal debt as a safe-haven option compared to other investment vehicles like equities. It is often seen that whenever there are signs of global tensions between countries on trades or other disputes, investors prefer municipal debt over other investment options.
On January 6, munis enjoyed their best trading day in two months as global tensions following the airstrike on Iran’s top general sent jittery investors in search of safe-haven opportunities, including munis and Treasuries. This was one example of tensions and uncertainties brewing around the world and investors are showing some skepticism toward the equities markets, even though equity markets have shown to be somewhat insulated post news like Coronavirus and other geopolitical events.
In 2020, investors are likely to take things into account that will have a larger impact on all financial markets, including Brexit, U.S. election year, Middle East relations, and talks of an upcoming recession.
On a slightly different note, pending recession talks can have an adverse impact on credit quality for many local governments and municipal issuers. Local governments derive most of their revenues from property taxes or sales taxes from their respective jurisdiction. This means that a financial downturn can impair tax revenues, in turn affecting creditworthiness and increasing the risk of municipal defaults.
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The Bottom Line
Municipal debt should be a strong contender for your pick of investments in your respective portfolios in 2020. The low interest rate environment will entice more issuers to enter the market to either refund their old debt or issue new debt for various projects, which means that supply numbers will likely remain strong similar to 2019. Furthermore, as more local governments are issuing taxable debt, investors should pay close attention to their tax status to see if taxable debt issued by a municipal issuer makes sense.
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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.