Municipal bonds rarely make headlines on election night, but few parts of the bond market are more tied to Washington. Their main attraction, interest that’s exempt from federal income tax, exists because Congress allows it. Their value to investors depends on tax rates that Congress sets. And the finances of the states, cities and hospitals that issue them depend heavily on federal money. So the Democratic sweep of the House and Senate on Tuesday deserves a close look from anyone holding muni funds.
The short version is that the result looks mildly positive for munis, with most of the effects coming through credit rather than taxes. But the details matter, and none of them take effect until the new Congress is sworn in on January 3.
Start with the tax exemption itself. During last year’s budget negotiations, ending or limiting the federal tax exemption on muni interest was floated as one way to pay for other tax cuts. It didn’t make it into the final bill, but the fact that it was discussed rattled the market for a time. Democratic leadership has generally defended the exemption, and state and local officials of both parties lobby hard to protect it. With Democrats in control of both chambers, and with Ron Wyden expected to chair the Senate Finance Committee, the odds of the exemption being cut in the next two years look low. That removes a tail risk that has hung over the market.
Tax rates are the next piece. Muni demand rises when tax rates are high, because the exemption is worth more. Last year’s tax law made the individual rate cuts from 2017 permanent, and that’s unlikely to change soon. Democrats may push for higher taxes on top earners, but any tax increase would need President Trump’s signature. For now, the realistic expectation is that rates stay where they are through 2028. That’s neutral for muni demand. High earners in the top bracket still get the most value from the exemption, and today’s tax-equivalent yields remain attractive.
The SALT deduction is a smaller factor, but it matters for investors in high-tax states. Last year’s law raised the cap on the deduction for state and local taxes from $10,000 to $40,000 for many taxpayers, with the higher cap phasing down for upper incomes. Many Democrats from New York, New Jersey and California want to go further. A larger SALT deduction lowers the effective cost of state taxes and can slightly reduce the appeal of in-state munis for residents of those states. Any change, though, would be part of a broader tax deal and is far from certain.
Credit is where the election could matter most.
Health care is the clearest example. Hospitals are one of the biggest sectors in the muni market, especially among high-yield issuers. Last year’s Medicaid cuts weighed on hospital credit, particularly for nonprofit systems serving lower-income and rural communities. Democrats have said they want to reverse parts of those cuts and restore the enhanced ACA subsidies. Even a partial reversal would improve the outlook for hospital bonds. Investors noticed. Shares of for-profit hospital owners helped lead the stock market’s rally on Wednesday. The same improvement in outlook should support hospital munis, and high-yield muni funds with heavy health care exposure could benefit from tighter credit spreads.
States and local governments are another. Federal money makes up a large share of state budgets, mostly through Medicaid. Cuts to federal support push costs onto states, which then have to raise taxes, cut spending or draw down reserves. A Congress more willing to fund Medicaid and other programs reduces that pressure. It doesn’t change state credit overnight, but it improves the trajectory.
Transportation and infrastructure could also see support. Federal grants fund a large share of transit, road and water projects. A Democratic Congress is likely to protect that spending, which helps the issuers that depend on it.
There’s a broader market effect too. Treasury yields fell after the election, with the 10-year dropping to about 4.89%, as oil prices tumbled and investors priced in gridlock. Muni yields tend to follow Treasuries, and lower yields mean higher prices for existing bonds. That’s good news for muni fund investors who have sat through a difficult year. The Fed’s December meeting is still a wild card, though. A hike would push up short-term muni yields and the borrowing costs of leveraged muni closed-end funds.
So what should muni investors do? For most, the answer is to keep doing what they were doing, with a few adjustments.
First, the reduced risk to the tax exemption is a reason for high-bracket investors to stay in munis rather than move to taxable bonds. The exemption looks safer than it has in two years.
Second, high-yield muni funds may be worth a fresh look, especially those with significant hospital exposure. Spreads in that part of the market widened after the Medicaid cuts and could tighten if federal support is restored. These funds carry more credit risk and more volatility, so they belong in a satellite position.
Third, investors in high-tax states should watch the SALT debate before making big changes to in-state versus national muni holdings.
Finally, keep perspective. Elections change the odds, but Congress moves slowly. Most of what matters for muni investors over the next year will still come from interest rates, the Fed and the steady demand of tax-sensitive buyers looking for income.
