February 2025 – Protecting Bonds and the Tax Exemption

Protecting Bonds and the Tax Exemption:

The long-anticipated study, eagerly awaited by municipal professionals such as MainLine West, has finally been released, although it came from a different source than the expected University of Chicago. While the University of Chicago remains active in this space, the Government Finance Officers Association (GFOA) took the lead. In their early 2025 report, they highlight the societal benefits of tax-exemption and argue why munis should remain tax-exempt. This month, we dive into the study, separating the drama from the practical insights. We also revisit the University of Chicago’s ongoing role in the muni market, which could potentially lead to a career shift for me.

In February, munis struggled through heavy supply, elevated yield volatility and were unable to keep pace with the taxable yield rally. It does not look any better for the next 30 to 60 days, as seasonal technicals are negative. Yet, in this modern age of Red Wave DC politics, it is anyone’s guess what the spring thaw will bring to muniland?

Muni Market Review

The muni market was unable to keep pace with the taxable market rally, underperforming for the month. Munis were up 0.99% MTD, 1.50% YTD; U.S. Treasuries were up 2.16% MTD, 2.68% YTD; and U.S. Corporates 2.04% MTD, 2.60% YTD. Munis are struggling due to heavy supply at the beginning of the year, and muni yield volatility is slightly higher than average, driven by the new Red Storm in DC. February highlights were as follows:

  • Muni yields were lower by 14 to 4 bps, while taxables were lower by 29 to 24 bps. The long end of the muni market was the biggest underperformer, as investors remained more conservative and leaned toward shorter maturities.
  • Among broader sectors, housing bonds were the best performers (1.23%), while General Obligation and Airports were the worst (0.91%).
  • Supply is off to a quick start, 9.5% higher than in 2024, which was a record year, and 15.3% higher than the five-year average. Building the USA with muni bonds!
  • Munis are slowly beginning to show good relative value, fund flows remain positive, but they are entering a typically difficult period for outperformance over the next 30 to 60 days.

MainLine has begun the liquidation of Fund V. Roughly 28% of capital has been returned. MainLine will continue to look for opportunities to liquidate the Fund. The next 30 to 60 days may be challenging, as we do not expect munis to perform well. The summer months may present our next good opportunity.

Market News & Credit Update:

  • At this moment, munis’ tax-exempt status is not on the chopping block. The Ways and Means Committee is led by a muni proponent who proclaims: “We have to protect the tax exemption for our municipal bondholders, full stop. The thing that we have to protect most is the municipal bond status for cities and towns across the country. As we look at the menu of options that are available to us, my goal in the committee is to ensure that removing the municipal tax-bond exemption is not on that menu for discussion.” Prepare for this to be an on-and-off game of red-light, green-light for muni exemption.
  • Year-to-date, downgrades and negative outlooks are slightly surpassing upgrades and positive credit rating outlooks—$4.20 billion compared to $3.99 billion. MainLine views this as the start of a credit deterioration trend that may continue for years and will provide further details in upcoming write-ups.
  • March has historically been a challenging month for muni performance. This March may be even tougher, as supply and demand technicals are not good, rate volatility remains elevated, and uncertainty in DC remains on the horizon. If munis can make it through the next 60 days, summer could be special for muni performance.

Protecting Bonds & Tax Exemption:

Introduction:

In January 2025, The Government Finance Officers Association released a study called “Protecting bonds to build Infrastructure and create jobs”. The municipal market took a proactive stance to defend its tax-exempt status, anticipating potential threats from the new red wave in DC.

Background:

This report examines the critical role that tax-exempt municipal bonds play in funding public-sector infrastructure projects. The report highlights how state and local governments, which account for more than 90 percent of public-sector construction spending, rely heavily on these bonds for projects like roads, bridges, schools, and utilities. Municipal bonds, unlike federal Treasury securities, are subject to stringent regulations under the Internal Revenue Code and state constitutions, ensuring their primary use is for financing new infrastructure.

Highlights of Study:

  • The savings between borrowing through taxable versus tax-exempt debt for municipal issuers is estimated to be 210 bps. So, if a tax-exempt municipality can borrow at 4%, this means as a taxable issuer it would borrow at 6.10%.
  • Using the lower tax-exemption borrowing rate, issuers on all bonds outstanding would save about $823.92 billion in borrowing costs over the next ten years (2026–2035).
  • Therefore, elimination of tax exemption would raise borrowing costs by $823.92 billion, a cost that would be passed on to American residents in the form of higher utility bills, property taxes, and medical and school costs, to name a few. This $823.92 billion breaks down to $6,555 per family annually (125.7 million households).
  • Revenue gained by the federal government by getting rid of tax exemption is estimated to be $750 per family annually. The net impact would be $6,555 a year, less $750, leaving the average family with $5,805 in higher costs. 

MainLine West Insights/Thoughts:

  • Only investment-grade issuers were used in the analysis to derive the 210 bps, which seems like a fair assumption. From work MainLine has done with taxable bonds, 210 bps seems to be realistic.
  • One big “drama” is that the study assumes all muni debt gets refinanced on day one. So, $3 to $4 trillion of munis start paying taxable borrowing rates right when the tax-exempt status is revoked. This is not true; bonds may become taxable on day one, but the borrowing rate the issuer is paying remains the same. The price of the bond will go down, yields up, but it will still mature or be called at par. The actual increase in borrowing costs would just affect the new debt issued, which is roughly $500 billion per year. The study is accurate once all muni debt gets refinanced, but this is a bit of a “drama queen” approach. It would most likely take 20 to 30 years to reach the $6,555 cost per family.
  • So, do you think the study is very biased and meant to be a headline number to scare politicians? Yes, you are right! But let’s just look at year one—$500 billion issued at 210 bps higher rate. That comes out to $829 per family in one year. This is already higher than the revenue savings of $750 the federal government would receive in year one. From there, it just keeps growing every year, and the loss of the tax exemption increases costs for society.
  • The study does not go much further about what comes next. How would munis borrow? Would they sell taxable bonds to retail investors? How does the city of Gary, Indiana borrow $16 million for its airport? Do you think anyone would care if it’s taxable? They could go to a bank, but that would come with an even higher borrowing rate. Depending on the issuer and the use of proceeds, MainLine thinks the 210 bps would be an average and would cost smaller rural issuers much more to build infrastructure.

Conclusion:

MainLine continues to believe the municipal market is the best way to build infrastructure for the following reasons:

  • The tax exemption status provides a cost savings to taxpayers.
  • It makes municipalities responsible to decide what they want to build and how they want to pay for it.
  • It provides all types of issuers, big, small, risky, and safe to access funds and take accountability for repaying them back.  

You can access the full study through the following link:

https://www.gfoa.org/protecting-bonds 

Here’s the real kicker: they are now offering a graduate degree with a specialization in municipal finance. In my days, munis were just one chapter in four years of Finance. I even once said in my book “The Birth of the White Swan” that if a university offered a course on munis, I’d teach it for free. Let’s keep that between us though—I’m getting too old for the Chicago weather!