The Impact of the U.S. Election on the Muni Market

Municipals

TheImpactoftheU.S.ElectionontheMuniMarket

By Jason Appleson, CFA, FRM, Sean McCarthy & Lisa Cole — Oct 8, 2024

8 mins

With the U.S. elections less than a month away, financial markets are left to ponder the implications of the possible outcomes— nearly all of which carry significant weight for the municipal bond market. To assist investors in navigating some of the relevant policy issues at stake, Jason Appleson, Head of Municipal Bonds, Sean McCarthy, Head of Municipal Bond Research, and Lisa Cole, Municipal Bond Credit Analyst, respond to key questions about the potential impact of the elections on the municipal bond market.

A: Municipal markets are sensitive to retail demand, which can fluctuate based on, among other things, an investor’s desire to shield income from taxation. Therefore, former President Trump’s (Trump) signature 2017 Tax Cuts and Jobs Acts (TCJA) is clearly among the most influential policies for municipal bonds. TCJA is set to expire at the end of 2025, irrespective of which party controls Congress. This would cause key components to be rolled back. For example, individual income tax brackets will revert to the pre-2018 structure with the highest individual tax bracket increasing to 39.6% from 37%.

We believe investors will likely respond to this change by increasing their demand for tax-exempt municipal bonds, which would provide a technical tailwind to support the sector. The implied tax rate between U.S. intermediate investment grade corporate bonds and intermediate investment grade municipal bonds is currently ~35% (Fig. 1). Investors with a tax-rate higher than 35% would be better off purchasing municipal bonds on an after-tax basis.

Figure 1

Implied Tax Rate between Tax-Exempt Municipal Bonds vs U.S. Corporate Bonds (%).

In addition, the TCJA significantly altered the exemption and income levels of the individual alternative minimum tax (AMT). These modifications also sunset at the end of 2025, adding back various items (e.g., exemption amounts and the phase-out thresholds) that subject more taxpayers to AMT liabilities. As a result, spreads on bonds subject to AMT could widen, driving the cost of capital for some municipal projects higher, especially airports that frequently issue AMT bonds.

Notably, the corporate tax rate, which was lowered from 35% to 21%, does not automatically revert to pre-TCJA levels, even though taxes for individuals will.

A: Both candidates are endorsing tax cuts. Trump has proposed more than $2 trillion in new tax cuts, including an exemption of tips from wages, while also proposing to extend the nearly $4 trillion in tax cuts under the TCJA. Vice President Harris (Harris) has endorsed an expansion of the child tax credit, a similar exemption on tips from taxable wages, and may seek to extend tax cuts under the TCJA for those earning under $400,000 (while increasing taxes on businesses and high-income earners). In addition, Harris has proposed increasing the corporate tax rate to 28%, increasing the stock buyback tax, increasing the ordinary capital gains tax rate from 20% to 28% for households making more than $1 million per year, and establishing a new billionaire minimum tax. Spending plans from both candidates could drive municipal bond market demand in different directions.

To fund Trump’s spending proposal, additional revenues will be required. One potential source of revenue could from eliminating the exclusion of interest earned on all or certain types of municipal bonds, including private activity bonds. However, we view the threat to the exemption as a low probability considering the importance of municipal bonds in building and maintaining U.S. infrastructure.

In contrast, municipal market implications may be more positive under Harris’ proposal. High earners, as well as banks and insurance companies, will be more incentivized to own municipal bonds given the potential for higher income tax rates. In the past, banks and insurance companies were large investors in municipal bonds but their holdings declined when the TCJA lowered the corporate tax rate to 21%.

A: The current federal fiscal situation complicates both candidate’s spending priorities and the feasibility of tax-reform. The fiscal deficit for 2024 is expected to exceed $1.9 trillion, or more than 6% of GDP.¹ Moody’s, the credit rating service, issued a warning on September 23 stating that the “incoming administration will face a deteriorating U.S. fiscal outlook.” The Congression Budget Office also anticipates that the stock of publicly held debt to GDP will reach 122% by 2034. Any tax proposal that extends tax cuts or increases the projected federal deficit has the potential to increase Treasury issuance, possibly adding some upward pressure to long-term interest rates and countering some of the effects of the Federal Reserve’s policy easing.

A: The following table summarizes several broad policy themes that could impact the credit quality of municipal bond issuers.

Aside from expiring TCJA provisions and tariffs (which a president can mandate unilaterally), most new policy initiatives will require bipartisan support or a united government in Congress. Investors should take comfort, regardless of the president elect’s agenda, the initial conditions in municipal market remain strong with reserves still at or near all-time highs. The credit quality in the municipal bond market remains among the highest across global fixed income (Fig. 2).

Figure 2

Municipal vs. Corporate 10-year Cumulative Default Rates (%)

The impact of the election on the municipal bond market is far from certain. In many cases, policies that are known today will have a mixed impact on municipal fundamentals as there are both positive and negative credit considerations. Furthermore, the fiscal backdrop in the U.S. challenges each candidate’s spending proposals, given current projections for growing fiscal deficits and public debt levels.

The biggest risks to the outlook for the municipal could occur in a scenario where a united government provides either candidate the ability to drastically affect tax and spending policies. Our base case is that the government will remain divided, making it challenging for either candidate to pass their policy proposals through Congress. Consequently, we believe various tax provisions of the TCJA will sunset, leading to higher demand for municipal bonds as individual income tax brackets revert to higher levels. In addition, we believe the SALT cap will be repealed. This would provide a boost to the disposable income of residents in high tax states and contribute to modestly to lower state tax collections.

1 Congressional Budget Office, “An Update to the Budget and Economic Outlook: 2024 to 2034.” June 18, 2024.

2 State expenditures are according to the National Association of State Budget Officers.

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By Jason Appleson, CFA, FRMHead of Municipal Bonds, PGIM Fixed Income
By Sean McCarthyHead of Municipal Bond Research, PGIM Fixed Income
By Lisa ColeCredit Analyst, Municipal Bond Credit Research, PGIM Fixed Income

Source(s) of data (unless otherwise noted): PGIM Fixed Income, as of October 2024.

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