Monitoring Tax Reform’s Impact on Municipals
The topic of taxes and their effects on individuals and businesses have permeated American conversations for hundreds of years, helping to shape the nation’s identity well before its official inception – an event in which taxes, of course, played no small part. To this day, they remain top of mind for many, especially with substantive reforms on the horizon.
While there is still much work to be done by Congress, such legislation creates potential impacts across many asset classes, and the first that comes to mind for many is the municipal bond market. There are a number of benefits that municipal bonds provide, but their tax-exempt interest income continues to be their most well-known. Although non-traditional buyers have shown more interest in recent years, due largely to these benefits, the market is still heavily influenced by the domestic retail investor, who accounts for nearly 70% of the market. The makeup of the investment market is one of the key reasons why supply and demand are both so important, as demand from tax-sensitive investors and the supply of new bonds can often exert significant influences on market valuations and performance.
Tax reform itself is obviously quite complicated and nuanced, especially at this point in the process, with two versions of the Tax Cuts and Jobs Act that investors should keep in mind. The first version of the bill was passed by the House in early November, while the Senate managed to pass its version over the weekend. That said, when we think about the impacts on the municipal market, it’s both instructive and straightforward if we break things down between the potential effects on investor demand and issuer supply.
The two versions have some meaningful differences, as they relate to the municipal market, but in both cases, we believe the demand for municipal bonds will remain high. The bill recently passed in the House is slightly more bullish along these lines, based on its proposed income tax rates. The House bill proposes reducing the number of brackets from seven down to four, but the top rate holds steady at 39.6%. In addition, an infrequently discussed provision creates a surcharge that leads to a tax rate of 45.6% for those making between $1.0 and $1.2 million. Meanwhile, the Senate’s version of the bill maintains seven brackets, while slightly reducing the top rate from the current 39.6% down to 38.5%, representing a minimal change for high-income earners.
While the House’s version would be more bullish from a demand standpoint, both leave top rates at levels that should continue to support robust demand for municipal bonds. We believe it’s also very important to note that neither bill includes any provision that would limit the amount of tax-exempt income an individual can receive. Previous iterations had considered such an item, but its absence further supports demand for municipals.
One additional point we would note is with regard to the deduction of state and local income taxes, or SALT, that primarily benefits high earners in states with high income tax rates. After initially calling for a full repeal of this deduction, the Senate’s bill was amended at the last minute, bringing this element of the proposal in-line with the House bill, which limits deductions for property taxes paid to $10,000 per year. Although the deduction wouldn’t be fully eliminated, municipal bonds from such states could still benefit from increased demand as their tax-exempt characteristics would become incrementally more valuable. This would be the case in states such as California and New York, two areas of the market where we continue to find attractive investment opportunities.
Figure 1: States with the Highest Income Taxes (2016)
Sources: IRS, Barclays Research, 4/28/17.
Potential Impacts for Supply
Here’s where things become a bit more interesting. In the House bill, which again was the first to pass, we have elements that would lead to a dramatic decline in the amount of supply, based on proposals that do away with advance refunding capabilities, as well as private activity bonds (PABs). Advance refundings allow an issuer to obtain the benefit of lower interest rates when their outstanding bonds that offer higher interest rates have not reached their callable date. While meaningful, these bonds represent a smaller portion of the market compared to PABs, which include airports, toll roads, not-for-profit health care, and private universities. Collectively, PABs typically comprise a significant portion of new issuance, often in the range of 20-25% depending on the year, and would thus represent a huge chunk of supply being removed from the market, especially when combined with the advance refunding component.
This is in contrast with the Senate version, which also eliminates advance refundings, while preserving PABs. As a result, the Senate bill still allows entities from the aforementioned sectors to continue using the tax-exempt market going forward. Overall, both versions would lead to reductions in supply, but the Senate’s would just be to a lesser extent. In any case, a positive for market technicals.
How This Bill Becomes a Law (Maybe)
Under normal circumstances, now that the Senate has passed its version of the bill, then representatives from both chambers would form a conference committee and proceed in rounds of back and forth, eventually crafting a compromise bill. That bill would then require approval from both chambers again before going to the President to sign into law or veto.
That said, circumstances are rarely normal in our nation’s capital, especially when it comes to major legislation. While we recognize that a number of scenarios are still possible at this point in time, we generally expect that the bill passed by the Senate over the weekend will be very similar to, if not the same, as the final version. Our opinion is based on the fact that the Republican majority is much smaller in the Senate, thus making a second passage more challenging, should significant changes come from the conference committee. This presents an important contrast to the House, where a stronger majority makes a second approval much more feasible. The Republican Party remains focused on signing a bill into law by year-end, but a number of obstacles must be overcome in a short period of time to make that happen.
Municipal Market Impacts and Portfolio Positioning
While tax reform and the impact on the municipal market have been a popular topic of conversation for some time, their actual effects have become apparent more recently, with spreads widening over the last week, as issuers have rushed to market in advance of potential changes. The primary driver of this activity is from issuers looking to advance refund their debt and lock in a lower coupon, since neither bill will allow for advance refunding next year.
Figure 2: Muni-Treasury Ratios Have Become More Attractive Amid Recent Underperformance
Sources: MMD DataLine, Barclays Research, as of 11/30/17.
Although this rush to market has caused spreads to widen and created some performance headwinds for the market, we believe the volatility has created attractive buying opportunities, allowing us to add incremental income to our portfolios and put cash to work. As we navigate this short-term increase in supply, we believe the portfolios will be well-positioned for what could be a strong start to 2018, a year that appears poised to benefit from the positive effects that potential legislation presents for municipal supply and demand.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
Municipal securities risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes which could affect the market for and value of municipal securities. Such uncertainties could cause increased volatility in the municipal securities.
Private Activity Bond (PAB) – Tax-exempt bonds issued by or on behalf of local or state government for the purpose of providing special financing benefits for qualified projects. The financing is most often for projects of a private user, and the government generally does not pledge its credit.
The Tax Cuts and Jobs Act of 2017 is a United States Congress bill to simplify the Internal Revenue Code of 1986, effectively altering the rate of taxation for individuals and businesses. The bill also calls for the elimination for several tax deductions.
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