Joni Ernst is the Republican nominee for U.S. Senate from Iowa. If she and her colleagues win control of the Senate, what bond market scenarios might we expect, and do these scenarios pose risks to the bond market? The Economist and The Bond Buyer do a wonderful job of mapping out scenarios of a potential Republican win of the U.S. Senate.
The bull case for bonds (in which rates fall and prices rise) could play out in a lame duck session for the federal government, where no significant laws are passed until the next presidential election in 2016. In this scenario the President pushes through executive orders on various issues, bypassing Congress.
In the worst case scenario, policies towards Iraq and Syria escalate. If this should occur, the risk-off trade will be your friend. The bear case for bonds (in which rates rise and prices fall) results from a more optimistic and amicable political process, where free-trade, corporate-tax reform and Federal Highway Trust legislation are fast-tracked and policies toward Iraq and Syria deescalate. In this scenario shorter duration and risk-on would your best bet.
In the background of each of these scenarios is the U.S. Treasury’s reporting an improved fiscal condition and the lowest Federal deficit since 2007. The improved Federal budget situation mitigates political risk around any potential drawn out debate on government spending and increasing the debt ceiling – both of which come up for reauthorization next year.
The main risk to tax-exempt bonds is a potential 28% cap on the tax benefit. Under the aforementioned scenarios, taking into account the improved government fiscal conditions, any risk to tax-exempt status of municipal bonds is reduced.
If anything were to happen related to taxes, corporate tax reform and tax inversions would likely take center stage. It is possible (though unlikely) that to pay for corporate tax reform, Congress may look for additional revenue by capping the tax exemption on municipal debt interest payments. It is our view that political inertia will likely prevail (in other words very little will get done in Washington) despite a backdrop of modestly improving economic conditions, which means interest rates will likely move modestly higher.
Source: NPR, The Bond Buyer, The Economist & Joni Ernst for U.S. Senate
This article was written by SNW Asset Management’s Samuel V. Hecker.