Factoring in the previous five coronavirus relief bills, Gov. Gavin Newsom’s office estimates nearly $615 billion2 in total federal aid is flowing into California. In addition to aid for state and local governments, this figure includes money for individuals, unemployment insurance and small business Paycheck Protection Program loans.
Backdrop Boosts State’s Credit Profile, Weakens Recall Movement
Already, the state’s fiscal windfall combined with steady economic gains is having a positive effect on the California muni market. The state is enjoying record general fund revenues—an important plus for the state’s credit rating. And those record revenues have occurred with only 45% of the jobs lost in the pandemic returning so far. (See also: Credit Rating Agency (CRA), credit quality)
In terms of spending, Newsom’s proposals include allocations for many initiatives, including homelessness, infrastructure, tax refunds for individuals earning less than $75,000 a year, and climate change. On a positive note, most spending is for one-time allocations, another favorable influence from a credit-rating perspective.
The federal aid at the governor’s disposal also has political implications. Newsom faces a recall vote in November. But given recent economic gains and all the governor’s spending plans, it seems unlikely voters will fire him. However, voters may put more pressure on Newsom to loosen the purse strings and commit to more recurring and longer-term spending. If he obliges, the state’s budget could be in trouble down the road, especially given the volatility of revenues.
Taxes Set to Soar
In addition to providing $5.2 trillion in coronavirus aid, President Joe Biden is seeking to spend another $4 trillion on infrastructure and various social programs. Eventually, the bill for this unprecedented spending will come due, and most of the payment burden will likely fall on corporations and wealthy individuals.
The responsibility for funding the infrastructure bill will largely go to U.S. corporations. The plan calls for hiking the corporate tax rate from 21% to 28% and enacting other increases (see “Infrastructure and Tax Proposals Lift Muni Market’s Profile.”) Higher corporate tax rates could lead to growing corporate demand for tax-advantaged munis.
Meanwhile, higher-income individual taxpayers and investors will foot the bill for the Biden administration’s various social programs. The proposal raises the top individual tax rate from 37% to 39.6%. Additionally, the plan sharply increases the capital gains tax on Americans earning $1 million or more. If this provision passes, high-net-worth investors in California would pay a total capital gains tax rate of more than 50%.
Furthermore, the administration wants to raise revenue by abolishing certain tax-reduction strategies. The tax proposals seek to eliminate certain tax-advantaged real estate exchanges, the step-up in basis at death and the carried interest provision.
California Muni Market Offers Opportunities for Investors
Demand for tax-exempt munis is already strong in high-tax states, including California. And these new tax proposals would only further boost investor demand for tax-advantaged assets. We’re already seeing the market pricing in expectations for higher taxes for many years to come.
Given our outlook for improving economic growth and higher interest rates, we’re positioning our California muni portfolios to take advantage of the yield we built in over the last year. We’re also looking to mitigate interest rate risk by focusing on less interest-rate-sensitive sectors and credit buckets. This means adding credits we think will improve as the economy continues to expand.
The reopening of the economy and the availability of COVID-19 vaccines continue to provide a broad market tailwind. To take advantage of this backdrop, we are overweighting lower-quality investment-grade securities and higher-yielding sectors, such as student housing, charter schools, multifamily housing and land-secured debt. These are all areas we believe still offer spread-tightening potential. (See also: spreads, spread sectors)
In anticipation of higher rates, we’ve reduced duration in our intermediate-maturity California muni portfolios, focusing on five- to 10-year maturities, where the curve is steep. Within our California high-yield strategy, we’re focusing on longer-term opportunities for credit improvement. Furthermore, we’re optimistic about the potential for advanced refundings to return as part of the infrastructure bill.
Overall, we believe the state of California is in much better fiscal shape than it was during the Great Recession. Unprecedented federal spending along with extremely loose monetary policy are paving the road for much stronger state and local revenues, which should result in surpluses. And this will give California’s state and local governments the ability to fund projects they haven’t been able to finance in the past.