The Big Bill and Bigger Picture Across the Municipal Bond Landscape

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Text on screen: John Nersesian, SENIOR CONSULTANT, ADVISOR EDUCATION

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NERSESIAN: Hi everybody! I'm John Nersesian, Head of Advisor Education at PIMCO. Thanks for spending some time with us today to discuss something that might be near and dear to all of your hearts. We know that on July 4th of this past year, President Trump signed into law the One Big Beautiful Bill, otherwise known as OB3, maybe the most significant piece of tax legislation or reform since the Tax Cut and Jobs Act of 2017.

And while many of the provisions of OB3 were simply to extend prior cuts enacted under TCJA, there's some new provisions as well. To help us learn more about the implications of this legislation on the $4 trillion municipal bond market. I'm so pleased to be joined by my friend and colleague, David Hammer. Dave is the Head of Municipal Bond Portfolio Management here at PIMCO. Dave, thanks for joining us today!

HAMMER: Hey, John! Nice to see you!

NERSESIAN: Dave, let's start at the top. Let's take a 30,000 foot view. We know that there was some concern about the retention of the tax exempt status of municipal bond income. Give us your view on the municipal bond market and where we should be looking for opportunities today.

Text on screen: David Hammer, PORTFOLIO MANAGER, MUNICIPAL BONDS

HAMMER: Yeah, you know, I think the biggest impact from the bill on the muni market, it's really what didn't change and first and foremost that's preserving the tax exemption for individual investors. We had a lot of clients that were concerned that that would be used as a pay for other tax cuts.

Number two would be keeping corporate tax rates the same. Corporate tax rates moving down from 35% to 21% back in 2017. Now that they're staying there, that means less demand consistently from banks and insurance companies who buy a lot of long duration munis.

That's meant a much steeper curve, about 145 basis points, tens, 30s today, in our view, that creates a really good opportunity for those investors that are in the highest marginal tax bracket to really extend duration.

FULL PAGE GRAPHIC – TITLE: 2025 Supply vs. Historical Average. IMAGE – Bar chart comparing 2025 municipal bond issuance to average gross issuance from January 2025 to August 2025. It shows that 2025 issuance has been significantly higher than the average across months.

You know, also for muni issuers, nothing changed. And this was a concern for muni issuers, many that they would lose the ability to issue tax exempt debt that caused many of them to rush to market earlier in the year and issue supply that may have come in the back half. You know, the one casualty for state credit specifically are Medicaid cuts. Medicaid dollars, it's the biggest transfer of federal dollars to state budgets every year. Over the next 10 years the cuts are about a trillion dollars. So it's big, but we think it's very manageable for state credit. About half the states will automatically just pass those cuts through. We think the majority of the others will let a lot of them flow through as well. And those that you know, may be tempted to backfill some of the lost Medicaid benefits for its citizens, they're in the best financial shape they've been in 25 years. Tax collections are near a record up about 35% from pre-COVID. In addition to that rainy day funds, reserves they've come off the records, but still, you know, very close to all-time highs.

NERSESIAN: Let's dive into some specific sectors, Dave. Let's talk about healthcare and Medicaid cuts that you referenced. What is the implication for that sector and maybe any specific issues that might be affected?

HAMMER: Yeah, the hospital sector is one where investors have to be really careful. It's about 15 to 20% of the investment grade and muni market. Hospitals were already under pressure prior to this due to higher wage costs. You know, a lot of that occurring during and after COVID and hospital affected service areas.

In addition to that Medicare and Medicaid reimbursement rates, they just haven't kept up with growing wage pressure. So, the casualty has been profit margins, they've been declining. Now there are winners and losers here, big systems that have managed to kind of right the ship here over the last couple years.

The OB3, the Medicaid cuts, that we're most concerned about is the impact on hospitals that have a lot of patients that are Medicare, Medicaid patients. Lower reimbursement rates cutting back on the eligible participants. It's going to be a strain on some of those hospitals. Those that'll be most affected have 50% or more of their patients that are either Medicare or Medicaid. These tend to be providers of last resort, safety net hospitals, and then a lot of standalone rural hospitals we think are most acutely affected. So these areas to be very cautious, we'd recommend avoiding entirely.

NERSESIAN: Let's turn our attention now to another sector that has been affected, higher education.

We know that there is now a greater or an increased endowment tax for those universities that have, I believe, over $500 million in endowments. Let's talk about that, Dave. Are there any challenges regarding student funding or some of the other student demand issues that might surface from this?

HAMMER: Yeah, so, you know, similar to healthcare, higher ed has been facing a number of headwinds bottom up across the country for a number of years. The challenges have been stagnant, if not declining enrollment trends as costs have increased. About a thousand colleges across the United States have closed since the year 2000 now.

The endowment tax, it only affects really the largest wealthiest private university. So it's, you know, about 50 or so will get hit by the tax. Fundamentally those credits are actually in very good shape. You know, we don't think it meaningfully changes the rating trajectory. These universities tend to have, you know, five, if not 10 times the endowment as a percent of debts. So the endowments are literally 10 times as much as total debt outstanding. Acceptance rates are in the single digits. So there's a lot of pricing power. So we're not worried about the fundamental credit picture on some of these, you know, that said, there are some new interesting challenges. I think the discussion around tax status and the eligibility to issue tax-exempt debt, you know, is a pretty important one. If a university was to lose its tax-exempt status, it's our view that the tax-exempt bonds would become taxable immediately, and that would mean a big negative mark to market hit for investors. So those are areas that we're avoiding.

NERSESIAN: Got it. Let's talk about something maybe most relevant to the individual investor. One of the components of OB3, the idea of the SALT tax deduction. As we all know, it was capped at $10,000 for all filers back under TCJA. There's an increase, of course, effective immediately at $40,000 for both single and joint filers, of course subject to a phase out for income levels above $500,000. Dave, what's the implication of this higher SALT deduction on the municipal market?

HAMMER: Yeah, so going back to 2017 when the SALT deduction was eliminated, it created a lot of inflows into California, in New York, muni bond funds as investors in those states just had less to choose from to shelter their income.

FULL PAGE GRAPHIC – TITLE: State and Local Tax (SALT) Deduction; SUBHEAD: Temporarily increased to $40,000 (subject to phase out). IMAGE – line chart how the SALT deduction phases out for taxpayers—going from a high of a $40,000 deduction down to a low of $5,000 based on filing status and adjusted gross income.

Now an increase from 10,000 to 40,000, we think it's a very modest reversal of that, but probably not enough to meaningfully change valuations for California, New York investors you know, all the way down to the 20% tax bracket at the moment, tax exempt munis are still attractive versus treasuries and corporate bonds, so we don't think the impact is significant.

NERSESIAN: Dave, any other closing comments about municipals?

HAMMER: Yeah, I think the, you know, the most damage that was done to the muni market this year, it actually occurred in advance of the OB3 bill. It was muni issuers that were afraid they would lose access to the tax-exempt market.

They rushed to market and issued a lot of bonds, in our view, pulled forward some supply that otherwise would've come the back half of this year. So munis have underperformed, you know, the IG muni index basically unchanged year to date.

So this underperformance, in our view, largely driven by technical factors, a lot of excess supply, not enough demand from traditional retail. What that creates is a really great opportunity, particularly in the long end. The tens thirties muni curve, it's about 145 basis points of positive slope right now.

FULL PAGE GRAPHIC – TITLE: Maturity-Matched Yield Curves. IMAGE – line chart comparing yields for AAA MMD Muni, Taxable-Equivalent AAA MMD Munis and Treasuries. It shows that yields for Taxable-Equivalent AAA MMD are significantly higher than both AAA MMD Munis and Treasuries.

That's about double the treasury curve. And just in terms of simple yields 4.5 to 5% tax free for a very high quality 20 year municipal bond, an investor would have to earn 7.5 to as much as 9% depending on their state and tax bracket to get that same after tax return, and in markets today, you'd have to take a lot more risk to get there.

So we see this as really an opportune time for investors to lock in the highest yields in almost 15 years potentially. Really lean into some of the longer maturity bonds due to the steepness of the curve where the markets underperformed the most and try to take some risk off the table in other parts of capital markets that look really quite rich, whether we're talking about equities or corporate bonds or high yield corporate bonds, where spreads are very, very tight.

NERSESIAN: Dave, I want to thank you. It's been a great conversation, and I want to thank our viewers for spending some time with us. If you'd like to learn more about the opportunities in the municipal market, we encourage you to contact your PIMCO account manager.

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