Setting a budget is never an easy task, but it looks as if the process has just gotten a lot harder for state and local officials, thanks to the federal budget proposal put forth by the Trump administration.
Like all such proposals, this one will face significant scrutiny and undergo an assortment of negotiated adjustments before it gets signed. Nonetheless, speculation about the proposal’s potential impact on state budgets – spending cuts? higher tax rates?—is already rampant.
During this time of uncertainty and flux – while budget negotiations begin in earnest and states start to determine how best to balance their own budgets – investors may want to consider allocating assets to single-state municipal bond funds, which are designed to generate net investment income that is exempt from federal, state and, where applicable, local income taxes.
Investing in single-state funds not only helps investors finance local projects, but we believe it can also help temper investors’ concerns about the near-term tax implications of the federal and state budget processes.
Already, a number of experts have provided their thoughts on the scenarios that may influence elected officials as they grapple with the ramifications of the federal budget proposal. As long-time investors know, the Oppenheimer Rochester team doesn’t believe in the power of crystal balls; that said, we do think it can be valuable to consider a range of perspectives when making personal investing decisions.
One such expert – Frank H. Shafroth, director of the Center for State and Local Government Leadership at George Mason University – has said that the federal budget proposals to increase defense spending and cut resources allocated to an array of domestic programs are likely to have a ripple effect on state and local budgets.
His concern, as reported in The Bond Buyer, is that “the President’s budget proposes to shift some $50 billion of domestic discretionary funding to defense, which would require exceptional cuts in programs affecting cities, towns, counties, public school districts, and states.”
As the debates on Capitol Hill ramp up, state and local officials around the country have begun voicing their concerns about the budget’s ripple effects. A quick Google search shows that many governors and mayors have spoken about the impact the current proposal could have on their municipalities’ business interests, economy and constituents.
Federal grants comprised 31% of state budgets in fiscal 2015, according to the Center on Budget and Policy Priorities, a nonpartisan research and policy institute based in Washington, D.C. that has written extensively about the subject. “Grants are at risk,” the center wrote in late February, “and states cannot absorb the magnitude of the potential cuts without reducing services.” In combination, mandatory and discretionary grants constitute 22% of state and local spending.
In an article on the website governing.com, Liz Farmer explains that “many programs beneficial to states and localities would be targeted,” including programs developed to provide direct federal aid to city projects, transportation-related grants, and education spending.
Simultaneously, elected officials must consider the possibility that state borrowing costs will rise. In March, the Federal Reserve raised the short-term rate that it controls, the Fed Funds rate, to a range of 0.75% to 1%. The rate had been held to historically low rates since December 16, 2008, when it was set to a range of zero to 0.25%. It held to this range for 7 years and, with the Fed’s March decision, has increased three times in a 15-month span. On May 5, the Fed decided to stay the course, saying however that it continues to expect at least two additional rate increases in 2017.
For Mr. Shafroth of George Mason, rising rates suggest that “the cost to states, cities, counties, and schools and universities to capital finance through the issuance of municipal bonds would increase—and likely increase substantially.” he said. (States are also dealing with the potential ramifications of the repeal of or changes to Obamacare, but that’s a separate story.)
Nearly all states are required to balance their budgets. Thus, if federal grants are reduced and interest rates rise, states may find themselves with unusually large budget deficits. One way to deal with these budget gaps is to lower spending on services. The other way, of course, is to raise revenues, through higher taxes and fees. Depending on the severity of the budget deficit, sometimes it’s necessary to do both—painful as it may be.
The municipal bond market can play an important role during uncertain times. States and local municipalities can typically issue muni debt to help finance important projects and, by doing so, free up other resources to pay for services that are important to their constituents. We have seen significant levels of long-term issuance in recent years, as officials sought to take advantage of the favorable rate environment. General obligation (G.O.) debt, which is backed by the full faith and credit of the issuing municipality, has historically benefited municipalities and investors alike; overall, we believe that the protections on G.O. debt are strong and that municipalities seeking unfettered access to the credit market recognize the importance of honoring their debt-service obligations in full and on time.
Further, despite the recent increases in the Fed Funds rate, it would be wrong to assume that the borrowing needs of state and local governments have lessened in any significant way. Dividend pressure is typically reduced for funds that acquire bonds that have higher coupons.
Muni bonds and muni bond funds, of course, have the potential to deliver competitive levels of tax-free income to investors, and the appeal of investing in muni funds increases when tax rates rise.
It’s far too soon to know how all of this will play out. Need we remind anyone that not all campaign promises come to fruition in a timely manner? And, there’s always the possibility that federal income tax rates could move in one direction while state and local tax rates move in the opposite direction.
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Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates, or an expectation of rising interest rates in the near future, will cause the values of a Fund’s investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at, or near, historic lows. When interest rates rise, bond prices fall and a fund’s share price can fall. Municipal bonds are subject to default on income and principal payments. Further, a portion of some funds’ distributions may be taxable and may increase alternative minimum tax (AMT) for investors subject to that tax; distributions from net realized capital gains are taxable as capital gains.
The funds invest in below-investment-grade debt securities, which may entail greater credit risks, as described in each fund’s prospectus. These securities (sometimes called “junk bonds”) may be subject to greater price fluctuations and risks of loss of income and principal than investment-grade municipal securities. The funds may invest substantially in municipal securities within a single state or related to similar type projects, which can increase volatility and exposure to regional issues. The funds may also invest substantially in Puerto Rico and other U.S. territories, commonwealths and possessions, and could be exposed to their local political and economic conditions. Deterioration of the Puerto Rican economy could have an adverse impact on Puerto Rican bonds and the performance of the Rochester municipal funds that hold them.