April showers may bring May flowers — but it’s also tax season. State and local governments may be particularly eager this year for income taxes to roll in from individuals and corporations as their pandemic-era stimulus packages start to dry up. Without the backstop of that federal support to supplement their tax revenue, how will they fare? Are there still opportunities for investors who want to invest in municipal bond portfolios?

We believe there are. Municipal bonds provide investors with federal tax-free income, which is valuable when the trajectory of the economy is unclear and the U.S. Federal Reserve is still holding rates steady. Prudent research and experience with bond selectivity will be important as dynamics shift and states are left to fend for themselves.

What’s the state of the states?

We believe state and local governments are largely in a healthy position in 2024 due to the impact of the stimulus packages. They are also in a good position on a historical basis. But is that true of every state? Not exactly. Governance matters. For example, New Jersey used the funds to better position itself to meet pension obligations. That’s a positive when we consider purchasing its debt.

In contrast, the city of Chicago and state of Illinois didn’t holistically address pensions with the stimulus funds. They still have underfunded pensions, which could lead to a shortfall in payments. This will likely be a problem for these municipal bond issuers in the future.

Other states are in a more difficult financial position after they cut taxes for residents and increased spending in one-time programs. California is more cyclical, with a graduated income tax structure reliant on the highest wage earners, so it could be exposed in a recession.

Our investment teams carefully consider the individual bonds of each state and locality on their own merits. And for some states and local governments, any future downturn — depending on its severity —will require them to address their financial stability.

Before the COVID pandemic, most state and local issuers were in fairly solid financial situations, but there were some outliers. Chicago, Illinois and New Jersey faced pension shortfalls. Then, the pandemic triggered massive job cuts. As layoffs increased, income tax receipts fell. If a person wasn’t working, they could not contribute income tax revenue to state coffers. In fact, total individual income tax revenue declined nearly 30% in the second quarter of 2020 versus the prior quarter. Spending also dropped over the same period due to city shutdowns, cutting the sales tax received by the states roughly 15%. The simultaneous fall in sales and income tax revenue could have been disastrous for states. A silver lining appeared in the form of the American Rescue Plan Act (ARPA), designed to shore up the country’s economic situation in response to the pandemic. The program ultimately delivered billions of dollars to state and local governments.

Economics began to shift as the year progressed. In the third quarter of 2020, as people began to return to work, revenue from individual and corporate income taxes more than doubled from the prior quarter. Sales tax revenues to states also increased more than 17% as consumers took advantage of the convenience of online shopping. This, combined with the stimulus dollars, truly boosted states’ coffers.

“Muni land” encompasses more than just the states

From toll roads to schools to bridges, our everyday environment is built by revenue bonds. While some states may fare worse than others in a recession, muni investors have other options. Up to now, in considering state and local issuers, the focus has been on the general obligation (GO) bonds that they issue as a promise to pay. The other universe of municipal bonds is paid through revenue streams. These are issued by revenue-generating services, such as toll roads or some other source that qualifies for tax-exempt debt. Muni investors rely on revenue bonds for their portfolios alongside GOs.

In general we tend to be more bullish on revenue bonds than GOs. While strong fundamentals have led many investors to favor GOs, their popularity is reflected in their pricing. As such, many look expensive on a relative basis, providing less opportunity to benefit from those bonds.

Revenue bonds are backed by specific revenue streams of specific projects, such as hospitals or toll roads, and generally require thorough analysis. This creates opportunities for active managers like us. Consider a corridor like the Ohio Turnpike. It could double its toll rates, and people would be unlikely to take a detour because it's such an essential roadway. It has an untapped pricing power it can exercise if needed — making it a potentially strong credit.

Planned amortization bonds (PACs), another type of revenue bond, are also attractive. These are bonds backed by the mortgage payments of single-family housing with a steady prepayment schedule. They typically have an average life (the average expected time to pay off a bond) of five years. While PACs require deep research for proper valuation and assessment, these structures can offer a strong credit profile and are insured by housing authorities. PACs can provide a yield premium in comparison to other short-duration, investment-grade (rated BBB/Baa and above) bonds, which is on par with some lower rated bonds.

The collaboration of our fixed income and equity analysts — a key feature of The Capital System^TM — helps identify opportunities and gain insights. For example, Delta, American and Southwest airlines issue tax-exempt bonds that are supported by ticket sales, baggage fees and other revenue-generating activities. Muni analysts often work with our equity analysts to determine if such bonds are suitable investments.

Truffle hunting in the bond market

When investor demand for new issues is strong, it can sometimes lead to mediocre or poor value. However, the secondary market (where securities can be traded after the initial offering) sometimes serve as a bargain bin for bonds — if properly researched. We are constantly on the hunt for such opportunities.

An example of an attractive sector in the secondary market is the student loan sector. We believe there is opportunity in this area because we are able to purchase high-quality bonds with strong underwriting standards (underwriters assess the credit worthiness and risks of the underlying loans) and attractive spreads (the difference between two yields that compensate investors for risk) at discount prices.

Leveraging a dedicated team of experienced analysts and traders who can uncover intriguing opportunities that may arise in the secondary market can help to add value.

How does the coming election figure in?

With November’s presidential election looming, there may be consequences for muni bond investors. Whoever wins will face the expiration of the Trump-era Tax Cuts and Jobs Act of 2017 (TCJA), scheduled to sunset at the end of 2025. This opens the door to a $1.8 trillion tax increase on January 1, 2026. The winning candidate will need to work with the House and Senate on a new tax bill. While it is anyone’s guess how the dust will settle come November, our base case outcome is a split government. That would likely mean an absence of meaningful tax reform and the expiration of the TCJA. The top tax brackets are more likely to increase in this scenario, which would make tax-exempt investments more attractive and could lift investor demand for municipal bonds.

For a similar reason, a blue wave (Democratic majority) could benefit municipal bonds, given the possibility of higher tax brackets and desirability of tax-exempt income. By contrast, a red wave (Republican majority) may result in an extension of or deepening of tax cuts, lowering tax brackets. If tax-exempt income is not as attractive, this could lead to less investor interest in municipal bonds.

Beyond the coming election, today’s markets are dealing with an uncertain economic growth trajectory and ongoing interest rate changes. A well-researched municipal bond fund, which can include both GO and revenue bonds, seeks to benefit investors across a range of outcomes.

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