Update: Monitoring Tax Reform’s Impact on Municipals
Updated as of 12/21/17
At the start of December, we shared our thoughts on tax reform and the potential implications for the municipal bond market. This immediately followed the Senate’s narrow passage of its tax reform bill, an event that we viewed as a particularly important milestone, based on our expectation that the final tax reform bill would prove to be quite similar.
In the days and weeks since, a conference agreement on the tax bill was reached, followed by successful passage in both the House (twice) and Senate. As the final bill moves on to the President’s desk, where it may potentially be signed into law by Christmas, we revisit key points from our original piece and account for recent developments.
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.
Tax reform 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 make-up 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 supply of new bonds can often exert significant influences on market valuations and performance.
Tax reform itself is obviously quite complicated and nuanced, particularly as investors were monitoring both versions of the Tax Cuts and Jobs Act in recent weeks. In the days and weeks following the Senate’s initial approval, a conference agreement was reached on the tax bill, which was subsequently approved by both the House and Senate. In terms of the impact to the municipal bond market, we believe it’s important to consider implications in terms of supply and demand.
The House and Senate versions had meaningful differences as it relates to the municipal market, but in both cases and as noted in our previous tax reform update, we believed demand for municipal bonds would remain high. While the House’s version would have been more bullish from a demand standpoint, both versions left top rates at levels that should continue to support robust demand for municipal bonds. The final version of the tax bill skews more towards the Senate’s version, reducing the top income tax bracket for individuals to 37%. While this represents a slight decline from the current tax rate, this is still a very high rate and we believe demand for municipal bonds will remain strong going forward. As anticipated, the final version doesn’t limit the amount of tax-exempt income an individual can receive, representing another positive with regard to investor demand.
As noted in our piece released in early December, the ability to deduct state and local income taxes, or SALT, 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, bringing this element of the proposal in-line with the House bill, which limits SALT deductions to $10,000 per year for those who itemize. 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)
Source: IRS, Barclays Research.
Potential Impacts for Supply
In the House bill, there were elements that would lead to a dramatic decline in the amount of supply based on proposals that do away with advanced refunding capabilities as well as private activity bonds (PABs). Advance refundings allow an issuer to obtain the benefit of lower interest rates when its 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. Ultimately, the final bill closely resembles the Senate version which eliminates advance refundings while keeping the tax treatment for PABs in place. While the reduction in supply is more modest as a result of PABs having no change, we still believe market technicals will be positive moving forward. At the same time, the market has experienced a significant increase in supply recently as issuers have been accelerating new deals as potential changes related to their municipal market access has been looming. We believe this supply increase is temporary and that municipal market technicals will be compelling in early 2018.
Municipal Market Impacts and Portfolio Positioning
While tax reform and the impact on the municipal market has been a popular topic of conversation for some time, its 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 the final bill does not allow for advance refundings next year. At the same time, new supply has been absorbed fairly well but the municipal market has faced some headwinds overall, particularly this week with year-end rapidly approaching.
Figure 2: Muni-Treasury Ratios Have Fluctuated Significantly as Tax Reform Efforts Have Progressed
Source: MMD DataLine, Barclays Research, as of 12/19/2017.
Figure 3: Weekly Results since the First Passage in the House Illustrate Short-Term Performance Headwinds
Source: Morningstar Direct, as of 12/19/2017.
Although this rush to market has caused spreads to widen, presenting some performance headwinds for the market, we believe the volatility has created attractive opportunities. As we navigate this short-term increase in supply, we believe the market is well-positioned for what could be a strong start to 2018, as positive technicals may follow these recent legislative developments.
New York Life, MainStay Investments, and its affiliates do not provide legal, accounting, or tax advice. You should obtain advice specific to your circumstances from your own legal, accounting, and tax advisors.
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.
Past performance is not indicative of future results. An investment can’t be made in an index.
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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