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Elections | Income

Quarterly Income Outlook: Sorting out mixed messages from the Fed and Congress

Chief Income Investment Officer Payson Swaffield notes that bond market investors are confronted with stark policy contrasts coming from Washington - the relative clarity of the US Federal Reserve compared with the murky picture posed by the congressional stalemate and the presidential election.
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By Craig R. Brandon, CFACo-Director of Municipal Investments, Eaton Vance Management

Boston - The US elections on November 3 have been a focal point for financial markets — chief among them municipal bond investors. We think the outlook for munis is uniquely tied to the outcome of the presidential and congressional races. As we consider the impact of different scenarios, let's turn to a so-called blue wave.

Scenario 2: Biden wins, Democrats take the Senate and keep the House

Assessment: Likely positive for muni bonds

  • In this scenario, we see upside for municipals from both credit and technical perspectives.
  • With Democratic majorities in both chambers of Congress, a sizable stimulus package similar to the $3 trillion Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act, which was passed by the House on May 15, is more likely to become law.
  • States and municipalities could get around $1 trillion in aid (as in the original HEROES Act), with Senator Schumer from New York City and House Speaker Pelosi from San Francisco overseeing significant funding to urban core areas.
  • As key provisions of the 2017 Tax Cut and Jobs Act (TCJA) could be reversed, we expect tax increases that would make the tax exemption of muni bonds more valuable for individual and corporate holders.
  • Among other changes, the top individual rate could go back up to 39.6% from 37%, dividends could be taxed as ordinary income for those making over $1 million and itemized deductions could be capped at the 28% tax bracket.
  • The provisions of the alternative minimum tax (AMT) rate that prevailed before the TCJA might also be reinstated, which could affect the nearly 98% of taxpayers who were no longer subject to the AMT after the TCJA.1
  • Raising the corporate tax rate to 28% from 21% would make munis more attractive for banks, life and property & casualty insurers, who comprise about a quarter of tax-exempt muni holders, according to Citi Research.2
  • The immediate market reaction could be that equities sell off in a "risk-off" trade, potentially driving US Treasury rates even lower — if that's possible — and boosting the relative attractiveness of muni yields.
  • Under a Democratic sweep, we could also expect more climate and environmental initiatives, and hence greater issuance of green muni bonds eventually.

Potential negatives

  • Limiting the muni exemption to help pay for increased fiscal spending. This almost happened under President Obama, until a last-minute agreement took it out of the Taxpayer Relief Act that passed at midnight on December 31, 2012. As Vice President under Obama, Biden could try to include that limitation in any tax package during his administration.
  • Removing the $10,000 cap on the state and local taxes (SALT) deduction and reinstating advanced refundings with tax-exempt bonds. Both the SALT cap and the tax-exempt refunding restriction have been strong positives for muni technicals since 2017, helping to reduce supply and increase demand — especially in California and New York.

Bottom line: Catching a blue wave — with a Biden presidency and a Democratic sweep of the Senate and House of Representatives — would likely be a big positive for municipal bonds.

1 Tax Foundation, "The Alternative Minimum Tax Still Burdens Taxpayers with Compliance Costs" by Scott Eastman, April 4, 2019.

2 Citi Research, US Municipals Strategy Focus: Municipal investor base - Federal Reserve snapshot Q2 2020, September 2020.

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