Muni Update: One way or another, tax reform likely to have an impact

11-14-2017

Now that both the House and Senate have provided details on their own tax proposals, the parlor games over reconciling the two versions are set to begin. How it all shakes out is far from certain, but there are a lot of commonalities that could well make it into a final bill. So I wanted to share some thoughts about the potential effect on municipal bond performance and expectations for muni supply and demand.

First, under both the House and Senate proposals, all $3.8 trillion of muni bonds would remain tax exempt. Recall that there had been concern in the months following the election that the tax exemption may be revoked, even on existing bonds, causing a correction in muni valuations as yields would rise and prices fall. That has not happened. The bills also allow all governmental issuers—states, cities, counties, municipally owned water, power & education providers, public universities and state and locally owned transportation providers—to continue to be able to issue tax-exempt bonds.

That said, changes currently under consideration could have two noticeable impacts:

  • Muni gross supply could be reduced significantly, with gross issuance declining as much as 25-35% or maybe more in future years. This would represent a large technical positive for existing muni bonds, and explains why muni yields have fallen relative to Treasury yields since the release of the House and Senate tax bills. The reductions could occur through either the elimination of so-called advance refundings (used by issuers to take advantage of lower interest rates to reduce their debt service costs), the elimination or narrowing of Private Activity Bonds (issued by a large group of private borrowers that currently access the tax-exempt market, including nonprofit hospitals, private colleges & universities, private senior living centers, social service providers and, at times, private-sector companies) or both.
  • The effect on demand is mixed and will take more time to play out. Individual demand for munis likely will be stable for some investors, higher for some and possibly lower for others. The elimination or capping of state and local tax deductions and the fact that top individual rates remain pretty high—38.5% in the Senate bill and 39.6% in the House bill—should support demand from the highest-income investors and from investors in states with high state and local taxes. But, lower tax rates for many other individuals not in the top bracket could erode demand a bit. On the corporate front, demand likely will decline given the lower 20% corporate tax rate in each bill, which reduces the incentive for banks and insurance companies to keep buying munis. At the same time, it’s not expected banks and insurance companies will be selling their existing muni holdings—each own about 14-15% of outstanding muni bonds.

Bottom line, the changes under consideration are neutral to a slight positive for very near-term performance. But, if implemented, they could narrow flexibility and sector diversification opportunities to muni investors in the longer run. Stay tuned; we’ll keep you posted.