Cumberland Advisors Market Commentary – The Warren Hedge

Author: John R. Mousseau, CFA, Post Date: November 20, 2019

In the past few weeks Senator Elizabeth Warren has risen to be neck and neck with Joe Biden in most of the national polls for the Democratic nomination. In some of the electronic betting polls, though, Warren is ahead of Biden by 5–6 points, depending on the day.
Market Commentary - Cumberland Advisors - The Warren Hedge (John Mousseau)
Warren has promised higher taxes, which would include not only higher marginal income tax rates but also wealth taxes applied against investment portfolios above a certain threshold. The wealth tax seems as if it could be a stretch unless there are decent Democratic majorities in the Senate as well as in the House of Representatives. The University of Iowa 2020 US Election Markets currently show mid-60s percentile voting for Democratic vote share versus a mid-30s percentile for Republican vote share. As we know from the last election, though, it’s the Electoral College vote that counts. Our viewpoint is that one hedge against the effects of a Warren presidency would be tax-free municipal bonds – particularly longer-maturity ones.

It’s time to start thinking about what a Warren presidency would mean. For starters, we can assume a higher marginal federal tax rate. What that rate would be is conjectural and depends on the makeup of Congress as much as it does on Senator Warren’s election. We are fairly confident that the top marginal rate would be above its level during President Obama’s term, at 39.6%. Add to that the Medicare tax of 3.8% that was levied on families with income levels over $250,000.

We are using 42% as a marginal tax rate for our purposes. In the chart below we utilize last week’s tax-free AAA municipal bond yield curve. We then calculate the taxable equivalent yield at the current top rate of 37%. (We are not adding in state taxes here, and of course there is a chance that a Warren presidency could bring back the deductibility of state and local taxes on federal returns.) Then we calculate the taxable equivalent yield at a 42% marginal tax rate and show the increase in taxable equivalent yield across the yield curve. Clearly, there is a larger benefit as you move out on the curve. The last column is an estimate of what the possible price change could be for munis if the marginal tax rate is upped to 42%. We estimated this by calculating what the price would have to be to keep today’s taxable equivalent yields in a market with higher tax rates. In other words, the market would need to improve (go down in yield) by the differential between the taxable equivalent yields.

Some caveats. We are assuming noncallability here so that bonds would not run into call features. That is a little tough, but long noncallable zero-coupon bonds would accomplish this. However, if there were a bond sell-off and more deeply discounted bonds were available, then our estimates would be appropriate. Of course, this hedge would mean nothing if long-term interest rates go higher. So a secondary question is whether a Democratic administration would bring spending to a level that, when combined with a low 3.5% unemployment rate, might produce a higher level of inflation (which would be transmitted through higher bond yields).

With longer-term tax-free bonds being cheaper than US Treasuries, longer-dated munis would have the biggest upward movement and provide the best value on a relative basis — all other things being equal.

It’s impossible to fathom what all the effects of a Warren presidency would be, but it’s hard to see tax-free munis being hurt by higher marginal income taxes.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
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