With the help of a brief flight-to-safety trade and hopes that the Federal Reserve will soon cut interest rates, perhaps by more than expected, bonds have gotten a lift. And muni bonds are participating in that upside.
Obviously, lower interest rates could benefit exchange traded funds such as the VanEck High Yield Muni ETF (HYD). But when it comes to munis, the financial pictures of issuing states and cities are important too. The $3.12 billion HYD follows the ICE Broad High Yield Crossover Municipal Index. The fund has returned an admirable 4% this year and sports an enticing yield of 4.29%.
HYD’s solid performance has been aided by states using coronavirus relief funds to bolster emergency reserves. That has supported the ability to tend to municipal bond obligations along the way. On the other hand, muni market observers may be concerned by slowing revenue in some states.
“For states reporting June data, median overall tax revenue growth for July 2023 to June 2024 (covering fiscal 2024 in 46 states) was 0.5%, with 16 states seeing yoy revenue declines,” according to a Fitch Ratings review of 38 states. “Total state tax collections from July 2023 through May 2024 were below the highwater mark set in 2022 but were still well above pre-pandemic trends, based on Urban Institute data.”
Encouraging State-Level Data
Bonds issued by California and New York — two of the highest tax states in the U.S. — combine for over 24% of HYD’s weight. Recent revenue collections in those states are essentially a split decision.
“In New York, which has a different fiscal year than most states, total tax collections in fiscal 2024 were $3.5 billion (3.4%) above adopted budget estimates, and tax revenues, adjusted for the July 2023-June 2024 period, rose 3.7%. In California, 2024 revenues fell $16 billion below the original budget forecast but were estimated to increase 6.5% yoy to $190.3 billion as of the enacted 2025 budget. Initial year-end reports indicate revenues outperformed this estimate by at least $3 billion,” added Fitch.
One way of looking at the above is that high income taxes aren’t always a guarantee of buffering against shortfalls as is the case in California. Likewise, some states that implemented income tax reductions didn’t experience significant shortfalls. That’s because high interest rates made their cash reserves more appealing. Ohio, which accounts for 3.54% of HYD’s portfolio, is an example.
“Many states had unexpected windfalls from interest income generated from unusually high cash balances and high interest rates. In Ohio and Indiana, surplus interest income of $289 million and $179 million, respectively, helped offset tax revenue shortfalls,” noted Fitch.
Beyond a roughly 10% allocation to Texas and Florida, HYD’s exposure to the no-income-tax states is low. Conversely, the ETF devotes almost a third of its weight to California, New York, and Illinois. Those three states have some of the highest tax rates in the country.
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