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Municipal Bonds

MuniNotes: Hanging hopes on the Biden administration

A staircase inside a glass building

MuniNotes highlights

 

With a new, Democratic president in the White House, municipal issuers and investors alike are eager for support and change. Issuers are hoping to see direct funding for state and local governments, as well as changes in regulations surrounding bond issuance. Investors anticipate changes in tax rates. Puerto Rico’s long road out of bankruptcy could come this year.

 

Credit report: Municipal issuers seek funding and revised regulations

For municipal issuers, President Biden’s most important proposal is for Congress to provide direct funding to state and local governments. In the first stage of his COVID-19 response package, the president proposed allocating $350 billion directly to state and local governments, in addition to $170 billion for schools and $20 billion for mass transit, for total grants equal to 34% of all tax revenue collected by state and local governments in the 12 months ended 30 Sep 2020. 

Under Republican control, the Senate rejected a bill from the House that included new funding for state and local governments, but such a measure has a better chance of passing now that the Democrats hold both chambers of Congress and the White House. As of this writing, the Democrats have taken steps to enact the president’s proposal via the budgetary process known as reconciliation.

But the path for enacting this proposal remains uncertain. Would aid to state and local governments qualify under the rules governing reconciliation? Alternatively, could a bill receive enough Republican votes to avoid a Senate filibuster? Would the Democrats eliminate the filibuster rule to enact such a bill? Would they support the states by increasing the federal share of Medicaid? Will the proposal that 10 Republican senators presented to President Biden, which does not include state and local aid, affect the amount ultimately included in the legislation?

On the regulatory front, municipal issuers are likely to advocate for proposals introduced in the last session of Congress, but never passed into law. They include the following.

Restoring tax-exempt advance-refunding bonds

Under changes to the tax code under the prior administration, issuers could only sell tax-exempt refunding bonds within 90 days of when the bonds could be redeemed. In 2020, that change in the law led to a 101% increase in the amount of taxable debt sold, much of it for refunding purposes. Meanwhile, tax-exempt issuance fell by 4%.

In his confirmation hearing for the position of Secretary of Transportation, Pete Buttigieg agreed with Senator Roger Wicker’s statement about the benefits of advance refunding, saying “Yes, as mayor, few things gave me more fiscal pleasure than to find that we could save taxpayer dollars by refunding previously existing debt.”

Increasing the amount of private activity bonds

The volume of private activity bonds that can be sold per state could increase from $75 to $135 per capita.

Increasing the amount of debt that can be sold by a small issuer of bank qualified bonds

This amount could be raised from $10 million to $30 million. As a general rule, banks and other financial institutions cannot deduct interest expenses allocable to tax-exempt interest earned on obligations acquired after 7 Aug 1986. They may, however, deduct 80% of their interest expenses allocable to tax-exempt interest on qualified tax-exempt obligations, which are obligations issued by governments that issue no more than $10 million in debt per year. During 2009 and 2010, the definition of a small issuer temporarily included entities that sold no more than $30 million in debt a single year.

Allowing issuers to sell taxable subsidized debt

Through the Build America Bonds program in 2009 and 2010, issuers were allowed to sell taxable bonds that would entitle them to receive a subsidy from the U.S. Treasury to cover part of the interest expense. As noted, the ban on advance refunding bonds has led to an increase in the supply of taxable municipal bonds while limiting the supply of tax-exempt bonds. Foreign demand for taxable municipal debt has been growing in recent years, which has helped to hold down interest rates on the limited supply of tax-exempt bonds being issued.

If tax-exempt advance refundings are again permitted, having the option of selling taxable subsidized debt would be one way of holding down interest expense on tax-exempt debt. A related issue, however, is that Senator Ron Wyden, who is slated to chair the Senate Finance Committee, has long supported the idea of replacing tax-exempt bonds with tax credit bonds, which would be taxable, but for which bondholders would receive a credit on their federal tax returns. The idea is that the amount of the credit would be the same for everyone, so that the magnitude of the benefit would not be greater for people in higher tax brackets.

The original Build America Bonds program allowed issuers to choose whether to have a credit go to bondholders or have a direct payment go to the issuer, but all chose to take the subsidy as a direct payment.

 

Municipal investors anticipate tax law changes

Increasing personal income tax rates

From the perspective of individual investors, the most notable feature of candidate Biden’s platform was the proposal to increase tax rates. The top marginal personal income tax rate is expected to increase to 39.6% from 37%. And the corporate tax rate, which had been cut from 35% to 21%, could rise to somewhere between 25% and 28%. Such changes would likely increase demand for tax-exempt bonds, especially from insurance companies and banks.

Repealing the SALT deduction limit

One of the changes most earnestly desired by residents of states with high tax rates would be the repeal of the $10,000 limit on the amount of state and local income taxes that can be deducted from federally taxable income. Such a change would make state and local taxes less burdensome, which might reduce the incentive for residents to move to states with lower tax rates.

However, according to an earlier estimate by the Congressional Budget Office, repealing that limit would cost about $90 billion in 2021. One possible way of paying for that loss of revenue would be to lower the exemptions under the alternative minimum tax (AMT), which requires taxpayers to add back, among other things, the state and local taxes that they deduct for regular tax purposes.

Repealing the SALT deduction limit would cost about $90 billion in 2021.

Credit Research Team

Even without a change in the exemptions, the AMT diminishes the benefit of being able to deduct state and local taxes by high-income taxpayers.

Adjusting capital gains taxes and itemized deductions

President Biden has also proposed that the long-term capital gains (and possibly qualified dividends) of taxpayers with incomes in excess of $1 million be taxed at the same rate as ordinary income. For most high-income taxpayers, that would mean a tax rate of 39.6% plus the 3.8% net investment income tax, not the 23.8% tax that applies to long-term capital gains of taxpayers with less income.

During the campaign, Biden said he would limit the tax benefit of itemized deductions to 28% for upper-income individuals. Thus, each dollar of allowable itemized deductions would lower one’s federal income tax bill by no more than 28 cents, even if the taxpayer is in the proposed 39.6% maximum tax bracket. One question is whether a new tax law would treat tax-exempt interest income the same way. Such a limit on the tax savings from tax-exempt interest income had been proposed repeatedly in budgets proposed under President Obama.

 

Puerto Rico reaches an agreement

Puerto Rico’s oversight board announced an agreement reached with creditor groups and the conditional support from several bond insurers in late February. The agreement restructures $18.8 billion of general obligation (GO) and Public Building Authority (PBA) bonds separated into eight distinct creditor classes and is supported by creditors representing more than 70% of the outstanding GO and PBA obligations.

Bonds will be exchanged for $7.4 billion in new GO bonds, a $7.0 billion cash consideration and a proportional share of a new contingent value instrument (CVI). The CVI, which will likely be taxable, will allow holders to benefit from outperformance of sales taxes, as measured against sales tax projections set forth in Puerto Rico’s May 2020 Fiscal Plan. Bondholders would receive 75% of sales tax collections above the baseline, up to annual and lifetime caps.

Projected recoveries vary by security

Based on fixed components only (cash and the GO takeback bonds) recoveries range from 67.7% on the benchmark 2014 GO bonds to 80.3% on the oldest PBA bonds. However, ultimate recovery values will be determined by the future value of the CVI. The new GO bonds are paid down quickly, with 50% of the new debt amortized within the first 10 years. Pursuant to the plan, Puerto Rico’s maximum annual debt service, inclusive of the new GO bonds and previously issued COFINA bonds, would be set at $1.15 billion, equal to just 7.6% of projected own-source FY20 revenues. Future debt service costs are materially reduced under the plan.

An agreement reached with creditors last year included new junior lien COFINA bonds as part of the concession package, but this has been replaced with the CVI. The cash contribution in the new deal is up about $1.1 billion from the prior agreement, reflecting Puerto Rico’s growing cash balances following stronger than anticipated revenue collections and savings from years of not paying debt service.

Offering conditional support

The plan support agreement does not address all outstanding obligations, including general unsecured claims, Employee Retirement System bonds, pensions and other outstanding clawback bonds. Bond insurers offered their conditional support to the GO/PBA deal, assuming they are able to reach an acceptable resolution on insured clawback revenue bonds.

The board plans to continue creditor negotiations, but must file a plan of adjustment with the Title III bankruptcy court by March 8. The confirmation process will likely take much of the rest of the year, and the plan is not expected to be confirmed until fall 2021. Legislation authorizing the new GO exchange bonds and proposed CVI debt will need to be enacted before Puerto Rico can exit bankruptcy.

Prioritizing the plan

Puerto Rico’s government signaled support for the plan, but has not signed-on, citing concerns about potential pension cuts that may still be included in the plan of adjustment filed with the court in March. However, newly elected governor Pedro Pierluisi is likely to eventually support a restructuring plan as long as it’s deemed affordable and does not require pension cuts.

Putting Puerto Rico on a path to self-governance, free of the oversight board, is an important priority for political leaders. Completing the debt restructuring is the first step. The new administration has reiterated its commitment to “get out of bankruptcy, pay debt and return to capital markets” since taking office. Barring any unforeseen disruption, this may be first administration with enough runway to see a plan of adjustment confirmed.

Exceeding budget projections with revenues

Strong revenue collections that are outperforming the budget, combined with the expectation of increased federal aid, also support bankruptcy exit in 2021. Through the first six months of FY21, general fund revenue collections were 0.6% lower compared to the same time period the prior fiscal year. Though fairly flat overall, revenues exceeded budgeted projections by over 20%. Consumption-related taxes which have led recent budget outperformance with sales tax collections up 32% for the half of FY21.

The government attributes the stronger than anticipated revenues to the inflow of federal funds to alleviate the pandemic as well as the disbursement of fund for reconstruction work. Favorably, pent-up federal disaster relief aid previously allocated to Puerto Rico is expected to be deployed at a faster pace under the Biden administration. Under the current stimulus package, Puerto Rico is set to receive a significant portion of the $4.5 billion earmarked for U.S. territories. The package also extends other federal programs like the child tax credit, the earned income tax credit and social security disability to Puerto Rico which would support the Commonwealth’s economic recovery.

Transforming PREPA

Puerto Rico Electric Power Authority (PREPA) may also be able to exit bankruptcy in 2021. The oversight board has indicated that it is working with creditors to implement its 2019 restructuring support agreement, despite not having the support of the Puerto Rican legislature. This plan contemplates the exchange of existing bonds for new bonds backed by a surcharge on PREPA bills. Over the past year, Puerto Rico has made progress in transforming PREPA, including bringing on LUMA to operate the system, and soliciting interest from outside parties to operate PREPA generation. In addition, the Biden administration is expected to speed up access to federal disaster funding, over $10 billion of which is slated for PREPA.

Investors can be hopeful

Puerto Rico’s bankruptcy and debt restructuring efforts have taken much longer than initially anticipated. PROMESA was enacted in mid-2016, nearly a year after Puerto Rico’s first default and the Commonwealth initially filed for Title III bankruptcy in 2017. Natural disasters, political upheaval, and the pandemic have all helped prolong the process, but it has still taken an inordinately long time.

Over the next few months, the court confirmation process for the plan of adjustment will be lengthy and contentious and some impaired creditors are likely to be crammed down. But investors who have withstood years of conflict and uncertainty in Puerto Rico can now be hopeful the Commonwealth may finally be on a path to exit bankruptcy this year.

Puerto Rico's elected leadership lists the plan of adjustment and bankruptcy exit as their highest priority.

Credit Research Team

Market statistics

Chart 1 Municipal-to-Treasury ratios tighten
High grade municipals are performing best in 2020
Chart 3 Municipal yields (%)
Chart 4 Total returns by sector (%)
Chart 5
Credit spreads have widened
Chart 7 Municipal-to-treasury ratios have increased to new levels
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Endnotes
Sources
Legislation proposed by President Joe Biden
https://www.whitehouse.gov/briefing-room/legislation/2021/01/20/president-biden-announces-american-rescue-plan/

Moving Forward Act H.R. 2
With provisions to increase volume limit on private activity bonds, and amount that can be issued for small issuer exemption
https://www.congress.gov/116/bills/hr2/BILLS-116hr2rds.pdf

Another bill to increase definition of qualified small issuer
https://www.congress.gov/bill/116th-congress/house-bill/3967/text?r=9&s=1

Congressional Budget Office on eliminating limit on state and local tax deduction
https://www.cbo.gov/system/files/2019-12/hr5377.pdf

Republican proposal for COVID relief
https://www.collins.senate.gov/sites/default/files/Proposed%20Sixth%20Covid%20Relief%20Package.pdf

State and local tax revenue
https://www.census.gov/data/tables/2020/econ/qtax/historical.Q3.html

ReOrg Research

Puerto Rico Oversight and Management Board

Plan Support Agreement dated 2/23/2021

Revised Plan of Adjustment proposal dated 2/10/2020

Puerto Rico Treasury Department 2/17/2021 press release


The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index. 

A word on risk
Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments. This information should not replace an investor’s consultation with a financial professional regarding their tax situation. Nuveen is not a tax advisor. Investors should contact a tax professional regarding the appropriateness of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.

Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen, LLC. Nuveen provides investment advisory solutions through its investment specialists. This information does not constitute investment research as defined under MiFID.

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