Municipal bonds have long been a safe-haven asset class for fixed income investors, but it’s also the most susceptible to the whims of politics.
For instance, the tax-advantaged nature of municipal bonds means that tax rates have a big impact on their valuations. Government spending also plays a key role in the supply of muni bonds over time.
Let’s take a look at how President Biden’s spending and tax plans could impact the municipal bond market over the coming years – and what it means for investors.
Be sure to check out our Education section to learn more about municipal bonds.
Massive Spending Could Boost Supply
President Biden’s $1.9 trillion fiscal stimulus plan and proposed $2.25 trillion infrastructure plan could set the stage for robust municipal bond issuance over the coming decade. At the same time, the $350 billion earmarked for state and local governments as part of the $1.9 trillion plan could reduce credit risk and enable more attractive interest rates.
While Republicans have floated a smaller package, the Democrats could use budget reconciliation to pass the $2.25 trillion piece of legislation through the Senate without Republican support. Moderate Democrats are pushing for a bipartisan piece of legislation, but it remains unclear if Republicans are willing to compromise on the package size and contents.
A robust supply of new municipal bond issuances could reduce yields by providing investors with a greater supply, assuming everything else is equal.
Check out this article to learn more about the implications of the massive $1.9 trillion American Rescue Plan Act.
Higher Taxes Make Munis More Attractive
President Biden aims to pay for his fiscal stimulus and infrastructure plans through higher taxes. In particular, the president would seek to nearly double the top tax rate on capital gains and eliminate a tax benefit on appreciated assets, known as the “step up in basis.” These measures could bring effective marginal tax rates to as much as 61%, according to the Tax Foundation.
Municipal bonds are not taxed at a federal level, and often not taxed at the state level, which makes them attractive to investors in higher tax brackets. For example, an investor that falls into a high tax bracket could use municipal bonds to achieve better risk-adjusted returns than corporate bonds if they aren’t responsible for paying tax on the income.
Tax increases would likely increase demand for muni bonds, which could lead to a rise in prices and lower yields, assuming everything else is equal.
Rising Inflation Risks Point to Higher Yields
President Biden’s massive spending plans have already sparked concerns over inflation. For instance, billionaire investor Warren Buffett recently said that he is seeing signs of inflation and spiking demand across Berkshire Hathaway’s businesses. 10-year Treasury yields have also rebounded from lows of around 0.5% to more than 1.5% in 2021.
Despite these concerns, Treasury Secretary Janet Yellen doesn’t believe that the spending will lead to runaway inflation because the boost to demand will be spread out over a decade. If inflation did become an issue, the former Federal Reserve Chair believes that the central bank and federal government has ample tools to address it.
Higher inflation could lead to higher municipal bond yields and lower prices as issuers are forced to pay more to attract investors, assuming everything else is equal.
Be sure to learn more about the implications of the recent hike in Treasury yields here.
The Bottom Line
President Biden’s spending and tax plans could have wide-ranging impacts on the municipal bond market. While higher taxes and more spending could send yields lower, rising concerns over inflation could have the opposite effect over time.
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