Macroeconomic challenges facing the municipal market as well as a possible buyer base shift if policy changes regarding the municipal bond tax exemption were among concerns muni market strategist Vikram Rai cited during a webinar Thursday.
The Volcker Alliance and Penn Institute for Urban Research webinar brought together a panel of experts to discuss "the rapidly darkening outlook for state and local budgets" and the implications for policymakers, taxpayers and investors, according to a description of the event.
Though states started 2025 projecting healthy cash reserves of nearly $300 billion, "the Trump administration's suspension of tens of billions of dollars in U.S. grants as well as potential cuts by Congress to federal Medicaid funds" will test that cushion, according to the description, which also cited the threat to the muni bond tax exemption, the impact of a global tariff war and the increasing prospect of a U.S. recession as further constraints on state and local budgets.
"So let's start with the macro environment, I'm worried about rates," said Rai, who, prior to
U.S. Treasuries "used to be the safe haven, and that, unquestionably, is being challenged now, " he said.
Rai also expressed concern over the potential for a "shifting buyer base" for municipal bonds.
"They talk about tax exemption costing the federal government about $300 billion, and they count that as revenue generation over the next 10 years," he said.
Whether a potential elimination of the tax exemption would be applied retroactively — which would make all existing bonds taxable — or would only be applied "prospectively" to future new issues "is a bit of a question," Rai said.
"Now, in theory, you can reach that [$300 billion] number prospectively, meaning that all new issuance will be taxed," he said.
From a practical standpoint, however, "it makes no sense," Rai said. Retail investors "buy munis for one reason and one reason only, and it's not [as a] safe haven, it's to save on taxes" he said.
"So if munis become taxable, that'll destroy the buyer base," he said.
Retail investors would have to be replaced by institutional investors, and that will take time, Rai said.
"So will the institutional investor buy the $25 million taxable deal? No, they'll not ... because they're used to more liquid markets," he said. "So, the notion that there'll be a seamless shift from tax-exempt issuance to taxable issuance, especially for the smaller cities … is just ludicrous."
Also during the webinar, the municipal strategist expressed concern regarding "blue state credit."
"I have been a muni strategist for 10 years, I have never started a year saying that I feel optimistic about the healthcare sector," Rai said. "And now this is especially true with all the attacks on Medicare and Medicaid — Medicaid to a larger extent."
Medicaid is "one of the largest expenses that all states have," Rai said.
"Now blue states, what could they do if they experience cuts to the federal funds for Medicaid?," Rai asked. "Well, they can actually cut benefits or increase taxes."
Cutting benefits is "not really in the DNA" for Democratic states, "it's not in anybody's DNA, I want to believe," the strategist said.
"Increasing taxes, given that the blue states already have higher taxes, that is a worry," Rai said, adding that he doesn't believe they have the ability to do so "and outmigration is a genuine problem" in states like California and New York.
States could also opt to defer pension payments, he acknowledged.
"We know Illinois has done that in the past, cities have done that in the past, but that will lead to downgrades," Rai said.
