The Day After in Bondland

November 9, 2016

“Destiny is not a matter of chance; it is a matter of choice. It is not a thing to be waited for; it is a thing to be achieved”
– William Jennings Bryan, 1899 (Democratic candidate for president in 1896, 1900, and 1908)
William Jennings Bryan was never elected president, losing to William McKinley twice and to William Howard Taft in 1908. However, he was the most successful Populist candidate for president… until last night. We now have a William Jennings Bryan with much better financing.
With a victory that upset polls and took until late into the night to be finalized, Donald Trump completed his mission of becoming the 45th president of the United States.
What follows is a quick update of the election and what it means to bond markets.
Treasury Rates
Leading up to the election, it was believed that a Trump victory would result in a “flight to quality” before government spending on infrastructure could accelerate interest rates. That was not the case, as 30-year Treasury bond yields increased the most this year and the 10-year reached an eight-month high founded on the market’s belief that the Republican candidate would increase spending to boost the economy. Throughout his campaign, Trump pledged to lower taxes and increase spending on infrastructure, both of which could intensify inflation and increase the budget deficit.
The 10-year Treasury climbed 20 basis points to 2.06% while the 30-year jumped 25 basis points, the largest increase in over five years, reaching 2.87%. Shorter-dated Treasuries rallied before backing off amid the belief that a Trump win would decrease the likelihood that the Federal Reserve will hold rates steady at the December meeting. The market-implied chance of a December rate increase dropped from 82% to 47% before rebounding back into the mid-70s. The initial drop in the rate-hike probability was fueled by the belief that the economy could not withstand higher rates under Trump. While we believe that the Fed will continue to maintain a cautious approach to raising rates, our expectation is that they will still move rates higher in December. We believe that the Trump campaign’s commitment to a higher growth rate for the economy will eventually lead to more borrowing, a higher interest-rate construct, and perhaps a higher level of inflation. We felt that to some extent this pattern would also have accompanied a Clinton victory, and so we have shortened duration in anticipation of higher interest rates.
Municipal Bonds and Infrastructure
On the municipal bond front, we certainly think that the Trump victory will result in infrastructure spending on a larger scale than a Clinton presidency would have done. Many factors are unclear, but we have been operating on the assumption that a Trump administration will invest roughly $1 trillion in a long-term infrastructure program, with a combination of government borrowing and tax credits to attract private investment.
Trump has promised to reduce marginal tax rates. Our best guess is a 33% top rate instead of current 39.6% The fate of the Obamacare tax now paid by families earning more than $250,000 is unclear; but an educated guess is that if Obamacare is overhauled, this tax may be gone as well. That would hurt municipal bonds at the margin because of lower tax rates. However, longer tax-free bonds have held at over 90% yield ratios to Treasuries, and AA and A rates bonds are still well over 100%. With a backdrop of rising Treasury rates, tax-free bonds should be cushioned somewhat, given their current cheaper relative value. In addition, the elimination of many deductions and exemptions may leave tax-free bonds as one of the few safe havens.
If Trump is able to get policies of lower taxes and less regulation through Congress, these could help our already-chugging-along economy and be a positive for municipal and corporate credit quality in general. Congress is now in Republican hands, which may bode well for these policies. If companies are allowed to keep a larger portion of their earnings in this country, there may not be a need for an extra tax on the importation of goods from domestic companies’ factories in foreign countries. An improving economy and prospects for positive growth, along with the ability to keep more of our hard-earned money, may cause more people to enter the workforce. Improved corporate earnings and growth could fuel the stock market and improve investment returns. Improved investment returns would help the growth of retirement and pension funds – a sorely needed development. Of course there are sectors that will face challenges, such as hospitals that have been ramping up to comply with Obamacare regulations. 
Infrastructure investment was always expected to get a welcome shot in the arm if either candidate won, as both emphasized the great need to invest in our crumbling infrastructure. This investment potentially includes programs to leverage local funds. The need for infrastructure improvements and the rush to take advantage of low interest rates, coupled with the current lack of federal help, have encouraged jurisdictions to take infrastructure development into their own hands, resulting in $70 billion in bond ballot measures, the majority of which are for school construction, transportation projects, and some water and sewer funding. As of this writing, the largest single ballot measure passed was $9 billion for schools in California, and nationally it looks like approximately half of the infrastructure ballot initiatives were approved.
The anticipated increase in infrastructure funding is also good for the municipal bond market because of expected matching funds or other types of programmatic support. The spending on infrastructure would be a positive to economic growth, which again would benefit municipal credit quality. If the federal government aggressively funds infrastructure development, there will be an impact on inflation expectations.
We are entering a period of uncertainty as the election results are sorted out; but with majorities in both houses of Congress, President-elect Trump will have cooperation in implementing his programs.
As we sit here on post-election day 1, we believe we are heading to higher interest rates (from an extremely low level), and we expect to see more in the realm of municipal finance, but tax-free bonds will still be the cornerstone. Any drop in marginal federal tax rates may be offset by the elimination of some deductions.
Puerto Rico Debt
Election activity was not just limited to the US mainland. Ricardo Rossello of the New Progressive Party (NPP) was elected Governor of the Commonwealth of Puerto Rico. Governor Alejandro Garcia Padilla, who is not seeking re-election, is a member of the Popular Democratic Party (PDP). The newly elected governor’s stance differs dramatically from the current administration and seems to be a positive development for bondholders. Mr. Rossello has stated he favors paying bondholder’s interest if they agree to extend principal repayment. He is also a supporter of statehood for the Puerto Rico and has voiced his commitment to promoting that position. He seems to be acting very quickly and has already stated he will write the oversight board a letter asking to renegotiate the commonwealth’s debt. Mr. Rossello stated that his administration is looking to renegotiate the commonwealth’s debt in good faith in order to comply with debt-service payments and provide Puerto Rico with access to the markets. In addition to Rossello’s victory, the NPP also became the majority party in both chambers of the commonwealth’s legislature.
The Local View
Meanwhile, here at our home office in Sarasota, Florida, we have had front-row seats to this year’s electoral spectacle. Florida, which political pundits have called the “Checkmate State,” was hit by a hurricane of television commercials, radio spots, and digital ads. Reams of direct mail from the national, state, and local campaigns have filled our mailboxes – so much so that they now lean right or to the left depending on party affiliation. Early last evening, Donald Trump secured Florida’s highly coveted 29 electoral votes, which foreshadowed the billionaire’s eventual victory over Hillary Clinton. Looking down the ballot, both houses of the Florida Legislature remained firmly in Republican control, with the governor’s mansion currently occupied by a Republican – a dynamic some refer to as a “trifecta.” Voters here also cast ballots on a constitutional amendment legalizing the prescription of marijuana for medicinal purposes. With the successful passage of Amendment No. 2, Florida, with its large population of seniors, may soon see a notable influx of revenues on both the municipal and state tax rolls from activities related to the production, distribution, and consumption of cannabis. This is a new economic dynamic that we will monitor as it relates to any municipal or state credits held in client portfolios.

Author gratefully acknowledges the assistance of Amy Raymond, Daniel Himelberger, Gabriel Hament, Patricia Healy, and Shaun Burgess in writing this commentary.

The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

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