Municipals exist at the crossroads of finance and politics. Given this, it would seem irrational to hold an opinion of the market absent an opinion of the political landscape. In contrast with previous elections, the subsequent relative performance of the asset class will likely not be a product of the events that unfold on election night 2020. The reason – low rates.
We are often asked for our thoughts on how this election will impact the municipal market. Conventional wisdom in the muni market is that, if a Democrat wins the election, taxes will go higher. In this scenario, more people will clamor for munis, and the asset class will rally. If a Republican wins the election, convention indicates that the reverse will occur. Looking at the past two elections, the market reaction has mostly followed this line of thinking. On election night in 2012, the 10-year Muni/Treasury ratio was 103% and declined 8% over the following month, indicating a municipal rally following President Obama’s election. In 2016, the 10-year Muni/Treasury ratio was 93% on election night, and climbed 4% over the same ensuing time period following President Trump’s victory. This highlighted a modest temporary underperformance for the asset class. While we are not saying the election was the only input to ratio movements here, it does seem rational to suggest it was a major input.
As election day nears, we find ourselves generally repeating what we have done coming into other election cycles – putting pen to paper, creating models around various tax rates to compare asset classes, and stress testing data series. While all elections matter, this one might not matter as much to the municipal market in terms of driving the technical backdrop, which can alter demand dynamics.
The reason for this lack of reaction is that, even if tax rates move in one direction or the other, absent a material uptick in rates, it just doesn’t change the math the way it used to. The 10-year Aaa Muni Rate is 0.71%. The top marginal tax rate (including the 3.8% ACA Tax) is 40.8%. Thus, the value of the exemption is under 30 basis points. Let’s say tax rates go all the way back to the top rate in American history, which was 92% from 1951 to 1953 (I can never pass on an opportunity to point out we used to have a 92% tax rate). The value of the tax exemption climbs to only 65 basis points, barely half its value just two years ago. So, while we are not forecasting who will win in November, and we are certainly not suggesting we will see a 90% or higher income tax rate, we believe that, given the low absolute level of rates, a change in the political landscape will have a more muted impact on the market.
So, what does the November election hold for the muni market? Below we highlight the five most important potential changes should there be a change in the White House, and the impact each could have:
- Additional stimulus and direct aid: Modern Democrats have historically been more willing to offer aid to struggling municipalities. Assuming a sweep by Democrats in November and a similar-to-today COVID situation, the potential for direct aid to municipalities will increase. This credit or fundamental dynamic for the market is likely the biggest impact on the muni market.
- Change in capital gains taxes: Former Vice President Joe Biden has advocated for increasing the long-term capital gains tax rate for top earners to that of the ordinary tax rate – an increase from 23.8% to 40.8%. Long-term, this would have a mostly muted impact on valuations, but it would likely create lower turn-over of bonds in the municipal market, as many investors would likely hold their securities to maturity rather than pay taxes on the large embedded gains in their municipal portfolio.
- Increase the Corporate tax rate: As noted above, a change in tax rates would have minimal impact on present valuations, but would provide an additional backstop to the market during periods of distress. An increase in the corporate tax rate brings crossover buyers into the market at higher valuations, thus reducing market downside.
- Elimination of State and Local Tax (SALT) deduction limit: Eliminating the cap on SALT deductions has been a fiscal priority for many coastal Democrats. While the potential for an elimination does increase following a sweep by Democrats, we view such a legislative change as unlikely given the material impact on the Federal Budget. However, if it were eliminated, this would be a long-term credit benefit for high-tax coastal areas, but a modest near-term valuation negative as the demand for “in-state paper” would decline slightly.
- Increase in the top marginal rate for individuals: Former Vice President Biden has pushed for rolling back the reduction of the top marginal tax rate resulting from the TCJA, and returning to rates in place during the prior period. This 2.6% increase in the top marginal tax rate is worth less than two basis points in municipal yield, and therefore would have virtually no impact on the market.
I hope you all make it to the election booth or cast a vote by mail come November. All elections matter. If you find yourself thinking about municipal valuations when you’re in the booth, I would say we should be friends, and that we are both overthinking some small numbers.
Sources: Bloomberg Barclays. Data as of 8/24/2020. The above examples are for illustrative purposes only. Actual results may differ. 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 views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.