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Fixed-Income Insights

Recent U.S. Supreme Court rulings have the potential to not only increase revenues but also to decrease expenses.

(Note: This article is from the forthcoming edition of The Muni Quarterly.)

U.S. state and local governments are most likely the first issuers that come to mind for many municipal-bond investors. Although credit quality generally has continued to improve post–financial crisis, and default rates in the sector remain as low as ever, headlines regarding sizable unfunded pension obligations and political brinksmanship in several states have cast a shadow on the sector.

Investors received some good news, however, in the form of two recent U.S. Supreme Court decisions: South Dakota v. Wayfair and Janus v. AFSCME. The cases, which have been well-received by the market, have the potential to not only increase revenues but also to decrease expenses for states directly, and local governments indirectly, providing additional flexibility and bolstering credit quality.

South Dakota v. Wayfair: Tax Revenue from Internet Sales

 

South Dakota v. Wayfair has freed up $8.5 billion to $13.4 billion in additional revenue for U.S. states.

 

The case of South Dakota v. Wayfair centered on the collection of sales taxes from retailers that did not have a physical presence in the state itself. In a 1992 decision,1 the U.S. Supreme Court issued an opinion in which individual states could not collect sales taxes on such firms—in effect, robbing the states of an increasingly important revenue source as online sales growth has continued to accelerate while physical storefronts have been closing their doors.

 

Chart 1. South Dakota v. Wayfair Will Result in Additional Revenue for States
New U.S. sales tax revenues as a percentage of 2017 budget

Source: U.S. Government Accountability Office,2 individual state budgets.

 

On July 21, 2018, the U.S. Supreme Court overturned the 1992 decision, potentially freeing up $8.5 billion to $13.4 billion in additional revenue for states. Using the midpoint of this estimate, states will see an average increase of $214 million, or 0.65% of 2017 revenues, which goes a long way to help balance the budgets of struggling states or fund new infrastructure projects. The biggest winner is Oklahoma, which will add an estimated 2.84% to its revenues, while the state with the lowest bump-up in revenue is Vermont, at an estimated 0.26% of its 2017 budget.3 This boon at the state level will indirectly improve local government credit quality as well, because it frees up more money for state aid.

Janus v. AFSCME: Right-to-Work Nation

 

Janus v. AFSCME effectively makes every state a right-to-work state.

 

On July 26, 2018, Justice Samuel Alito penned the opinion for Janus v. AFSCME,4 detailing that mandatory union fees paid by nonmembers were unconstitutional under the First Amendment right to free speech. This decision could have a profound impact on both labor union membership and influence, as it effectively makes every state a right-to-work state. More important for the muni investor, this judgment will, over time, diminish the strength of municipal employees in compensation negotiations and labor disputes, potentially reducing state and local government employee costs and slowing wage inflation for non-right-to-work states. The impact on wages will have a twofold effect, as governments will save in the current year on salary, but also in the future, as defined pension benefit calculations heavily rely on the salaries of the underlying employees. (We offered an in-depth look at pension funding in the second-quarter 2018 edition of The Muni Quarterly.)

Some of the more distressed states, such as Illinois, New Jersey, and Connecticut, have high union membership and may benefit most as result of the ruling. According to the Union Membership and Coverage Database, the average monthly payroll is 14.7% lower for states and 21.9% lower for local governments in right-to-work states, while the average state pension funded ratio is 10% higher. The additional flexibility for expenditure and the resulting decrease in pension pressures is a credit positive for those states that had not already implemented right-to-work laws.

Although the outcome of these cases is favorable, the rulings are unlikely to have an immediate impact on credit quality. However, these rulings eventually should provide many state and local issuers with additional financial flexibility. We will continue to follow the sector closely and report on trends as they occur.

 

1Quill Corp. v. North Dakota, 1992

2U.S. Government Accountability Office study, “Sales Taxes, States Could Gain Revenue from Expanded Authority, but Businesses are Likely to Experience Compliance Costs,” November 2017.

3Note that Alaska, Delaware, Montana, New Hampshire, and Oregon do not levey a sales tax.

4American Federation of State, County, and Municipal Employees.

 

IMPORTANT INFORMATION

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The credit quality of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principle on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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