Separately Managed Accounts

Boston - Financial markets have a laser focus on the November 3 elections in the US — and perhaps none more so than municipal bond investors. We could even argue that the outlook for munis may be uniquely tied to the outcome of the presidential and congressional races. Let's consider the impact of different scenarios, starting with a continuation of the status quo.

Scenario 1: Trump wins, Republicans hold the Senate and Democrats keep the House

Assessment: Likely negative for muni bonds

Special situations: Illinois, New Jersey, New York and California

• President Trump and many Republican senators have referred to states like IL, NJ, NY and CA as having mismanaged their finances and pensions, and thus not deserving of a federal bailout that would reward their bad behavior.

• We would agree that Illinois and New Jersey have indeed been mismanaged, but our annual State of the States update suggests that New York and California are in pretty good shape. Our analysis found that the other bottom-ranking states are actually Kentucky (48), Pennsylvania (47), Louisiana (44), West Virginia (43), Mississippi (42) and Kansas (41).

• Nevertheless, many Republicans are strongly against any more aid to states and localities. They would rather open up the economy to get tax revenues flowing again, and they may be using these so-called blue states as examples, whether accurate or inaccurate. We suspect there could even be some partisan profiling of NY and CA to get back at leadership rivals in the Senate and House, respectively.

• With a smaller probability of CARES 2.0 getting passed — or at least a package with more funding to state and local governments — there's a possibility that lawmakers in IL, NJ and NY could raise taxes. In fact, CA has already hinted at looking for revenue gains from top earners. Such actions would likely drive demand for munis in these states.

Bottom line: Maintaining the status quo — Trump presidency, Republican Senate and Democratic House of Representatives — could be a negative for municipal bonds.

Eaton Vance Investment Tax Center
Election 2020 could have major tax and investment implications for your clients. Stay on top of them all with our tax-forward insights and needs-based solutions.

Eaton Vance Parametric Investment Tax Calculator
Taxes always matter. See your clients' combined total tax rate, including federal, state and local taxes, right now and hypothetically under the Biden Tax Plan.

New York - Four weeks away from the US presidential election, the potential tax policy changes by a Biden-Harris administration would represent a significant departure from the status quo, as we have discussed in previous blogs. So it stands to reason that investors in fixed income separately managed accounts (SMAs) should consider what might happen if there is a new resident of the White House in 2021.

The municipal market is particularly sensitive to tax rate changes, especially tax increases. Starting in 2017, for example, the Tax Cuts and Jobs Act (TCJA) reduced the top federal income tax bracket from 39.6% to 37%. Nevertheless, high-net-worth investors sought muni bond exposure because the TCJA also limited the deductibility of state and local taxes (SALT).

Biden changes tax policy

Under a Biden presidency — and particularly under Democratic control of Congress — a proposed reversion to the 39.6% income tax bracket for the highest earners could increase demand for municipal bonds. That might result in lower yields and higher prices — thus increasing their value for existing investors.

The SALT cap could also be repealed, and this would be a positive for muni investors. However, with the individual tax rate returning to its pre-Trump level, the actual effect on bond prices or yields would likely be negligible.

Another significant change involves Biden's proposal to increase the corporate tax rate to 28%. This may lead corporations to add some muni exposure. Although that corporate rate wouldn't be as high as in the pre-TCJA era, we believe the increase in demand from corporations may result in price appreciation for existing bonds.

Lastly, the ability of fixed income SMAs to harvest tax losses¹ on a year-round basis could prove to be beneficial for high-tax-bracket investors seeking to offset gains. Biden's proposal for all capital gains to be taxed as ordinary income for those earning more than $1 million may lead these investors to further seek out tax-loss harvesting options.

Democrats take control

If Democrats end up controlling both chambers of Congress, we could see an effective tax regime change in 2021. However, the consensus is that in light of the economic impact of the 2020 health crisis, a significant tax bill would likely take a backseat to COVID-19 recovery and other stimulus. Tax policy changes could take most of next year to complete and would likely have an effective date at the beginning of 2022.

Bottom line: Under a second Trump term, muni demand would remain high due to the current SALT cap and the low chances of further tax reductions for individuals. However, tax-exempt investors may have more to gain under a Biden presidency, since the likelihood of individual or corporate tax rate increases could improve the relative value of their fixed income holdings and increase the demand for tax-exempt investments.

¹ Tax loss harvesting is a strategy for managing taxes in an investment portfolio. Selling a security that's trading at a loss creates a realized tax loss, which can be used to offset a capital gain realized in the same year.

Eaton Vance Investment Tax Center
Election 2020 could have major tax and investment implications for your clients. Stay on top of them all with our tax-forward insights and needs-based solutions.

Eaton Vance Parametric Investment Tax Calculator
Taxes always matter. See your clients' combined total tax rate, including federal, state and local taxes, right now and hypothetically under the Biden Tax Plan.

Boston - With Labor Day in the rearview mirror, bond market investors are confronted with stark policy contrasts coming from Washington: the relative clarity of the US Federal Reserve compared with the very murky picture posed by the congressional stalemate and the presidential election.

Here are our takeaways in the current environment:

Market volatility is likely to increase, with the path of COVID-19 infections as the overarching uncertainty factor. An example is the pace of school reopenings — the normal productive capacity (and spending habits) of parents may be significantly reduced if they have to continue as stay-at-home teachers.

Fed policy is clear: Lower short-term rates for longer (through at least 2023 based on the September policy meeting) with a bias to let inflation run above its 2% target until the unemployment rate is very low. The Fed's stance has resulted in inflation expectations creeping up from 1% last March to 1.7%, as indicated by the 10-year inflation breakeven.¹

Corporate bonds have benefited greatly from Fed policy, which has included purchases of corporate investment-grade debt and high-yield ETFs. This has contributed to a general tightening of credit spreads to pre-COVID levels, with the exception of floating-rate loans.

In leveraged credit, transparency about anticipated defaults is now better, and we believe that defaults won't reach the levels we expected in March. In our view, loans have lagged other credit sectors because the floating-rate feature was viewed as a negative. But with rates at rock-bottom levels, we believe loans offer value, because we don't expect the Fed to resort to negative short-term rates.

By contrast, a cloud hangs over the municipal bond market, with no agreement in Congress over new relief for cities and states. The muni market has nevertheless rallied, driven by investor hunger for yield, leaving the high-quality sector less attractive on a risk-adjusted basis. Certain high-yield muni bonds — BBB or lower — may offer better risk-adjusted return. For example, hospitals were hard hit by COVID-19 and prices fell in March, but they have bipartisan support in Washington. A potential Democratic sweep would certainly be a significant tailwind for the municipal sector.

¹ Inflation breakeven is a commonly accepted measure of the expected inflation rate, defined as the difference in yield between nominal Treasury bond rates and the real yield on Treasury Inflation Protected Securities (TIPS).