Refresh yourself on the calculation for tax-equivalent yield and learn why it matters given the new tax rules.
One market trend we have closely monitored this year is the sharp drop in California municipal bond spreads. While several factors – including market technicals, particularly supply and demand – have contributed to this spread movement, the main engine driving this dramatic tightening is the Tax Cuts and Jobs Act (TCJA). Tax reform has bolstered demand for in-state tax-exempt bonds from investors in high-tax states like California, New Jersey and New York, as tax-exempt municipals are one of the few tax-preferred vehicles available.
CALIFORNIA SPREADS ON THE MOVE
California spreads have fallen significantly year-to-date (Figure 1), and spreads have tightened further in recent months. California bonds have been trading at yield levels that are lower than the “AAA scale,” which is a proxy for the overall level of yields for high-quality general obligation (GO) bonds. As an example, at the start of 2018 an AA-rated, 5-year local California bond traded about 1 basis point (bp) lower than the AAA scale. Since August, a similar bond has traded between 25bps and 30bps lower than the AAA scale.1
REASONS FOR THE SPREAD DECLINES: THE SUPPLY AND DEMAND STORY
California spread levels have dropped primarily due to a combination of strong demand (due primarily to tax reform) and limited supply.
The Demand Side
As with all states, demand for tax-exempt income in high-tax states drives the prices investors are willing to pay for municipal bonds. With the passage of the TCJA, taxpayers are now limited to $10,000 in deductions for state and local taxes (SALT), which consist of two parts: (1) a deduction for state and local property taxes, and (2) a deduction that can be used for either state income taxes or state sales taxes, whichever is higher.2 The $10,000 limit is the combined cap for both parts 1 and 2.
This matters because prior to this tax law change, high-tax investors who found value in bonds outside their state of residence could take a federal tax deduction on all state tax paid on the interest income generated from those bonds. However, with the $10,000 cap on SALT deductions, demand for in-state tax-exempt income has risen dramatically in states like California where residents’ potential SALT deductions exceed the cap, putting downward pressure on spreads (Figure 2). Among U.S. states, California ranked third-highest in the average amount of SALT deduction, with an average of $18,438 per resident, per 2015 data from the Bond Buyer.
The Supply Side
California has been the top state issuer of municipal bonds in eight of the last 10 full years.3 The state has issued $33 billion in municipal bonds year-to-date through August 2018, which is 15 percent of total supply for the period.4 With tax reform, however, gross municipal issuance has dropped due to the elimination of advance refunding deals, and annual supply is expected to decline between 10 and 15 percent for the full year 2018, per the Bond Buyer. California issuance has dropped 30 percent year-to-date, which has contributed to this spread compression.
THE INVESTMENT PERSPECTIVE
Since supply and demand trends have driven spreads lower, it is important for investors to look closely at the credit trends in the state. California investors must determine whether the spreads offered, and the tax advantages of investing in-state, are enough to compensate for the state’s credit risks.
The credit profile of California has markedly improved in recent years, as evidenced by multiple ratings upgrades that have lifted the state’s rating to the AA range, versus the BBB range in 2010. Supported by Gov. Jerry Brown’s fiscal stewardship and strengthened by its large and vibrant economy, California has prospered, with its economic recovery outpacing that of the nation. The state’s current score from the California Legislative Analyst’s Office Fiscal Health Index is 97, which is close to the all-time high achieved in the early 2000s. That Index assesses economic conditions in California based on 10 key indicators.5
Cities and school districts have benefited from a strong state partner. The latest budget states that California’s K-12 schools and community colleges will continue to receive the largest share of the state’s tax dollars, with $2.8 billion more funding than expected.6
However, California bonds do not come without risks, including the state’s highly volatile tax structure with increasing dependence on personal income taxes – which currently account for about 70 percent of general fund tax revenues (Figure 3). During the financial crisis, when high-income residents wrestled with losses, California’s tax revenue declined sharply and its budget deficit grew to $40 billion. A modest downturn could wipe out the nearly $16 billion in current general fund reserves, negatively impacting local governments and potentially crimping growth. Additionally, the $10,000 cap on the SALT deduction may cause high-income taxpayers to relocate. While this may not impact the state in the short term, the state’s budget may feel the effects longer term because the deduction is not indexed to inflation.
In addition, the state is exposed to federal policy changes on trade, immigration and health care. California also is challenged by a high cost of living, a high poverty rate, sizable infrastructure needs and risks associated with climate and natural disasters.
As we continue to watch the state closely, key themes for our investment decisions are as follows:
- We continue to believe California is a stable credit that can offer tax advantages for many clients, but there are some risks and it is important to weigh the risks versus the spreads offered in the market.
- The investment team seeks to balance across pricing anomalies, different obligors and sectors, and market technicals, and is always working to maximize after-tax, risk-adjusted returns for clients.
- While there are compelling reasons to invest in California bonds, our investment team may opt to purchase out-of-state municipal bonds, taxable bonds or U.S. Treasury bonds in lieu of an in-state bond, provided that we believe it could generate more after-tax income based on the client’s specific tax bracket.
 Bloomberg, Thomson Reuters TM3 Municipal Market Data and Breckinridge Capital Advisors, as of September 25, 2018.
 For more details, see https://www.vox.com/policy-and-politics/2017/10/30/16557554/the-state-and-local-tax-deduction-explained.
 The Bond Buyer.
 The Bond Buyer, as of August 31, 2018.
 For more information on the state fiscal health index for California, see https://lao.ca.gov/LAOEconTax/Article/Detail/304. The 10 key indicators as of July 2018 are: Home prices, home sales, residential and commercial building permits, the S&P 500 stock market index, venture capital funding, unemployment insurance claims, CalFresh claims, port traffic and new car sales.
 John Myers and Liam Dillon, “Gov. Jerry Brown offers part of a historic budget bonanza to help ease California’s homelessness crisis,” Los Angeles Times, May 11, 2018.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.
Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.
BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices.
Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.