The issuance of taxable municipal securities has leapt to record levels since mid-2019 against a post-tax-exempt advance refunding backdrop of historically low rates, persistently low municipal-to-U.S.-Treasury ratios, and heightened interest from an expanding global pool of investors.
Bringing back a permanent, direct-pay taxable bond program similar to Build America Bonds would likely push that figure much higher, turning taxable munis from “scarce product to viable market,” according to strategists at Morgan Stanley.
“We see scope for a new BABs program to create up to $880 billion of issuance over five years from inception,” Morgan Stanley strategists Samantha Favis, Michael Zezas and Barbara Boakye wrote in a report.
They go so far as to forecast that issuance of taxables could, in time, overtake tax-exempts.
Taxable municipal bonds now make up nearly 30% of issuance since the onslaught of the product began in mid-2019. That figure is higher if corporate CUSIPs are included. If BABs are eliminated from the taxable total in 2009-2010 and market share in those years, the 2020 figures are the highest on record, with 2021 coming in slightly below last year's pace.
Last year's record $480-plus billion of issuance was 30% taxable. In 2010, taxables including BABs made up nearly 36%.
Even with an overall increase in taxable and tax-exempt volume in the past year and half, investors are clamoring for more municipal bonds because new-money paper is scarce and cannot meet demand from redemptions.
Direct-pay bonds would be another taxable tool for issuers to expand their investor base further via international investors and insurance companies, among others.
How likely a direct-pay bond program could make it through negotiations and into actual law in Washington is still highly uncertain. What is certain is that some form of infrastructure bill is must-pass legislation because federal-aid highway funding is set to expire in October.
Democrats, who control both chambers of Congress, are pursuing a two-pronged infrastructure approach that includes a bipartisan compromise package focused on surface transportation funding and a more sweeping Democrats-only agenda expected to be passed via the budget resolution process to prevent Republicans from blocking it with a filibuster.
The bipartisan bill is continuing to be hammered out. Senate Majority Leader Chuck Schumer, D-N.Y., held a procedural vote Wednesday on a "shell" bill as a way to formally agree to begin debating the measure, but it lacked enough support to pass.
Adding to the uncertainty is the potential for inclusion of tax-exempt advanced refundings in an infrastructure package.
State and local groups have made reinstatement of the product, eliminated by the 2017 Trump tax overhaul, a top legislative priority. Muni advocates are hopeful one of the infrastructure bills eventually passed will include the reinstatement, and that goal has the stated support of Rep. Richard Neal, the Massachusetts Democrat who chairs the tax-writing House Ways and Means Committee and has been one of the strongest advocates for the municipal market over his years in Congress.
If advanced refundings are revived, it is likely that tax-exempt deals would replace at least some of the taxable refunding volume. Taxable direct-pay bonds would still take up a hefty portion of overall debt simply because of the promise of direct subsidies from the federal government.
But how would a direct-pay bond program — a permanent one without the possibility of sequestration — play out for the market going forward?
Supply outcomes in Morgan Stanley’s model “can vary substantially based on assumptions on coupon subsidy, issue size, relative level of net yield savings to the issuer, and eligible use of proceeds,” the strategists say.
Much is dependent on that subsidy rate. Morgan Stanley’s $880 billion figure over five years relies on a 35% rate, same as the BABs had in 2009-2010,
“The scenario, most consistent with our observation of the potential for taxable issuance to grow … results from both a healthy coupon subsidy and higher yield ratios," they said. "While this is intuitive, given that higher subsidies and higher relative tax-exempt yields both decrease the relative cost to the municipality of issuing in taxable form, it is important to appreciate how sensitive the total supply output is to small changes in these factors."
Their projections also rely on the structural market dynamics that have been present since the global financial crisis — less buyer diversity, elevated demand sensitivity to rates volatility, proclivity toward mutual fund outflow cycles — persisting, even as credit quality holds up.
Market-driven growth assumes lower subsidies but the factors above would persist in keeping muni/UST ratios elevated and direct-pay bonds would still be strong, exceeding $700 billion over 10 years in its model.
Lower ratios and lower subsidies would "suppress potential new taxables supply to a trickle," less than $90 billion over five years, they said, noting that if a new direct-pay model began that way and was sustained, "a transition to a market defined by more institutional demand would be indefinitely delayed."
"Our core conclusion is this: with a BABs program, the taxable market would grow into the dominant form of issuance, albeit slowly at some times and quickly at others," the report said. "Our model output shows that more generous subsidies and higher yield ratios (i.e., relative tax-exempt to taxable yields) drive a sharp increase in expected taxable supply."
Of course, an actual law needs to be passed for any of these scenarios to play out.
Schumer said on Thursday he remains committed to both infrastructure approaches.
"My colleagues on both sides should be assured: as majority leader, I have every intention of passing both major infrastructure packages — the bipartisan infrastructure framework and a budget resolution with reconciliation instructions — before we leave for the August recess," Schumer said. "I laid out that precise schedule both publicly and privately and I intend to stick with it."
