After tax reform, muni bonds remain attractive
More than a quarter removed from U.S. federal tax reform that impacted the nation’s municipal bond market, munis remain a sought-after investment vehicle. While the new tax law has altered the landscape, it has run up against another, more fundamental law: supply and demand.
The most significant aspect of the tax legislation on the muni bond market was its elimination of advance refunding bonds. With this debt accounting for around 30% of the muni market in 2017, total bond issuance was guaranteed to take a hit. Although not exclusively for this reason, this was the case in the first quarter as the number of municipal bonds floated fell 26% below the year-ago period, and we project it will be at least 30% lower for all of 2018 versus 2017.
As difficult as this has been for municipalities and other local entities, the drop-off in supply should be advantageous to investors as the reduction has not been met by a drop in demand—Investment Company Institute data show flows of more than $11 billion into municipal bonds in the first quarter. We do not expect the appetite of institutional buyers such as banks and insurance companies for municipal debt to change materially over time. Munis continue to offer an attractive mix of safety, total-return potential and low correlation with other investments.
And what of the cap on individual income-tax deductions? Again, what is unfortunate for taxpayers likely will benefit investors. With few tax-advantaged investments left outside of their 401(k) portfolios, muni yields after taxes are still attractive to investors. The Merrill Lynch municipal bond index currently has a yield of 2.69% pretax and 4.25% on a taxable equivalent basis (adjusting for the new 37% tax rate). This still compares favorably to the Merrill Lynch U.S. corporate bond index yield of 3.83% and the 30-year U.S. Treasury yield of 2.84%. We believe that factors like these and the mismatch in demand and supply likely will drive municipal debt prices higher in favorable markets and that these bonds likely will provide stability in volatile markets.