Muni Watch: Post-election, what's next?

11-16-2016

The surprise victory of Donald Trump as well as the Republican sweep of Congress has prompted a sharp repricing of bonds, municipal bonds included, in reaction to the prospect of greater fiscal stimulus, tax cuts and potentially larger budget deficits. Both Treasury and municipal yields have risen and the yield curve has steepened, reflecting higher inflation risk and, in the case of munis, tax risk, generating near-term losses in both sectors. All that said, Treasury and municipal bond total returns remain positive year-to-date.

As for municipal bond performance under a new Trump administration, there has been plenty of speculation about tax reform, including President-elect Trump’s proposed reduction of marginal tax rates and, more to the extreme, speculation that broad tax reform in an all-Republican government could include a repeal of the tax exemption on municipal bond interest. We believe the former is likely and the latter is not. 

Regarding tax rates, Trump has proposed cutting marginal rates (including a reduction in the top marginal tax rate from 39.6% to 33%), the removal of the 3.8% Obamacare surtax on high-income taxpayers and a reduction in capital gains rates. These reductions, if carried out, are bound to have some impact on investor behavior as lower tax rates reduce the value of the tax exemption that motivates high-income investors to own muni bonds. That said, we have seen the market reaction to tax changes many times before, and it is manageable. For instance, under former President George W. Bush, when top marginal tax rates declined from 39.6% to 35% in 2001 and 2003, muni bonds went through some temporary underperformance but ultimately posted competitive total returns relative to Treasuries and investment-grade taxable bonds.

Going forward, the market is likely to continue pricing in the prospect of lower marginal rates over time. That would suggest about a 20-to-30 basis-point backup in intermediate and long-term municipal bond yields if Treasury yields hold roughly steady. If Treasury yields continue to rise, the backup in muni yields will be somewhat more. Such performance is a short-term challenge, but not a substantial threat to investors. In the meantime, until we have more clarity on the coming tax, growth and inflation environment, we expect to stay somewhat short on duration to reduce potential volatility.

As for the municipal bond tax exemption, we think repeal is unlikely. For one, Trump has not proposed eliminating it. More significantly, this discussion has been repeated many times in the past, and each time state and local finance and policy officials have made it clear to their respective U.S. representatives and senators that they don’t want to increase the cost of capital for their taxpayers. Given the importance of state and local governments in providing infrastructure—a key component of the Trump administration’s platform—and the fact that many in Congress once served at the state and local level, we believe the municipal tax exemption will continue to be supported in Washington.