Dislocation, squeezed states, and a few winners: What tax reform means for municipal bonds
The first comprehensive overhaul of the federal tax code in 30 years will bring changes for municipal bond investors and issuers alike. As a quantitative manager, we specialize in finding opportunity in times of change. As experienced investors, we also view the outcome of the revamp as support for the municipal market, the Original Impact Investment. We believe that municipal bonds will continue to provide compelling investment returns and social value while serving as cornerstones of well-constructed portfolios.
For decades, from the high tax days of the New Deal and Great Society eras, to the tax-cutting climates of the Reagan and Bush administrations, the appeal of municipal bonds has been consistent: attractive after-tax income for most federal taxpayers, modest volatility relative to stocks and treasury bonds, and low default rates relative to corporate bonds. The Trump tax reforms have broadly preserved these long-term fundamental strengths, but with a few notable exceptions among certain issuers and investor types.
Dislocation ahead: institutional demand on the up in some states, while institutional interest wanes
Tax reform has increased the potential for a period of volatility as bond issuers and investors alike adjust to the new rules. The likely result is a shift in the balance between supply and demand that could produce a short-term dislocation in the muni market.
The new tax rules take effect amid the ongoing search for yield that has occupied investors since ultra-low interest rates became the norm, following the global financial crisis. In these conditions, we see the potential for retail investors to become anxious over the credit quality of some muni issuers, or exit the muni market to chase the alluring returns of equities. We would view any fear-based or greed-based outflow from the muni market as a buying opportunity, rather than as a structural devaluation. Indeed, in our view, the more severe the dislocation, the better the opportunity.
Past dislocations have been followed by quick rebounds and a powerful pull to an equilibrium ratio to US Treasury securities. As the below chart shows, since 1994, there have been 5 instances in which 10-year muni bond total return has fallen 6% or more from its peak. The median time to complete recovery was 13 months.
Downturns and recoveries in the muni market
As the above chart shows, since 1994, there have been 5 instances in which 10-year muni bond total return has fallen 6% or more from its peak. The median time to complete recovery was 13 months.
While behavioral finance certainly matters, and the impact of retail investor sentiment on markets should not be overlooked, supply and demand dynamics matter, perhaps more for markets over the longer term. We expect the supply of municipal bonds to decrease by as much as 30% as a result of tax reform, while bond maturities will likely exceed new issuance by as much as $50 billion, or up to 15% of the total market. The reduction in supply is expected to be driven by the elimination of “advance refunding,” a financing technique that allows an issuer to obtain the benefit of lower interest rates even when their outstanding higher-rate bonds cannot be called. Volume related to new financings should persist, or grow, as communities must modernize essential infrastructure and social services.
While supply will most likely tighten, demand will increase from some investors. Individuals in high-tax states will see their federal taxes rise due to the elimination of the widely-used tax deductions for state and local taxes. They are likely to seek the tax-free income available from munis issued by the states in which they reside. The cut in the top individual tax rate from 39.5% to 37% is unlikely to deter muni demand from individuals. Tax equivalent yields remain compelling, even when the elimination of the 3.8% Affordable Care Act surcharge is factored in, and especially considering the lower risk profile of muni issuers.
However, institutional demand is likely to wane. Corporate income tax rates are set to drop from 35% to 21% for the insurance companies and banks that currently hold nearly 30% of outstanding municipal bonds, reducing the appeal of munis’ tax-free income for them. Insurance companies, who hold 14% of the muni market [source: SIFMA], also face a dramatic increase (from 15% to 25%) in the “haircut” tax on muni income; their effective tax rate on municipals rises from 5.25% to 14.75%. Insurance companies may opt to sell munis in favor of high-quality investments with superior post-tax income; banks are more likely to hold existing positions, as the new economics are not as severe. Softening of valuations in preferred quality and maturity ranges of these buyers presents an opportunity for long term investors.
High-tax states, cities, and even improving credits face challenges
Jurisdictions that have not maintained low tax rates on their citizens are vulnerable to future financial pressure. The capping of federal tax deductions for state and local taxes — or “SALT” for short — will make living in these places more expensive for high earning residents. Over time, voters may put pressure on their governments to seek other solutions for their ongoing revenue needs, rather than permitting reflexive tax increases. The wealthiest taxpayers may also opt to move to lower-tax states, particularly as the baby boom generation retires from the careers they built when residing in locales such as New York, California and New Jersey. Flight of this high-earning tax base could harm these states’ and cities’ ability to generate revenue, and limit their ability to maintain spending levels through taxes hikes on a shrinking population of high earners. In order to balance budgets, state governments could reduce subsidies to local governments for schools and other public services.
These high-taxing jurisdictions will also likely feel the effects of the capping of SALT deductions in the form of declines in property values and property tax revenues. Expensive housing in areas such as the Northeast and California have long been effectively subsidized by federal taxpayers elsewhere, not only through federal deductions for property taxes but also through the the deductibility of mortgage interest. Property valuations among high-end vacation communities are particularly vulnerable. The Trump tax reform reduces the amount of mortgage interest that can be deducted, which in turn reduces demand for high-end properties, and lowers property values and property tax revenues.
Besides high-tax states and cities, another group of municipal bond issuers may find little to like about tax reform. While we do not see them as directly harmed, issuers whose credit fundamentals are actually improving have lost the ability to advance refund high-cost debt that they issued when credit spreads were wider. That prevents some of the more disciplined issuers from taking advantage of the lower financing rates which accompany improved credit fundamentals. In the long run, the inability to refinance high cost debt means that issuers will face higher issuance costs.
The few muni winners from tax reform: low-tax states and Alternative Minimum Tax bonds
Governments that don’t levy high taxes on their citizens should benefit from tax reform. States such as Texas and Florida that do not tax their residents’ incomes, and towns and cities with low property tax rates, will have increased flexibility to raise revenues in the future. They will also likely benefit, along with the country broadly, from a potential increase in overall economic activity, resulting from the reduction in the corporate income tax rate. A stronger economy is a harbinger of increased capital gains, income and sales tax revenues. Property values and tax revenues could also rise as an indirect result of the corporate tax cut.
And it’s not all bad news for high-tax states. Due to SALT, these regions could see increased demand as in-state investors seek the greater tax shelter of same-state munis. The potential rise in valuations from this demand should benefit issuers, who are likely to see their financing costs compress. For example, we could expect CA and NY residents to direct investment to their home states, and less demand for issuers in TX and FL.
Bonds subject to the Alternative Minimum Tax (AMT) are among other beneficiaries of tax reform. The income level at which the AMT applies has been raised to $1 million for couples and $500,000 for single taxpayers. As a result of the change, the yield premia associated with the AMT have compressed by 0.10 to 0.15% [source: Neighborly Investments]. Bonds subject to the AMT account for approximately 5% of fixed-rate muni bonds outstanding [source: Bloomberg].
Private activity bond issuance is on the rise again
Among those bond issuers who benefit under the new tax code are communities seeking to improve their access to energy and information.Congress kept intact the tax exemption for “private activity bonds” or “PABs” issued by state and local governments. These bonds fund projects such as the construction of small-scale microgrids and fiber optic data networks that increase communities’ access to — and control over — critical energy and information resources. Communities also issue PAB bonds to fund schools, hospitals, airports and public housing, all of which will remain tax-exempt. The preservation of PABs is critical to preserve the powerful role of the municipal market in modernizing and democratizing the infrastructure and services that communities can deliver to their constituents. Council of Development Finance Agencies tracks the annual issuance of PABs. The figure below shows that issuance has been on the rise since the great recession. The year-over-year growth was about 57% from 2015 to 2016.
Source: Council of Development Finance Agencies (2017)
And now, the much-promised infrastructure deal?
With tax reform a done deal, infrastructure investment is the next great policy frontier with implications for municipal bond market investors and issuers. The Trump Administration came into office pledging to rebuild and expand our country’s infrastructure by leveraging “existing programs” to stimulate efficient and significant capital investment. Depending on the success of this initiative, municipal bond issuance could skyrocket. The muni market has historically financed three quarters [source: Congressional Busget Office March 1, 2017] of infrastructure investment in the United States, and could be the critical accelerant to drive capital flows into our communities. We will continue to closely monitor implications of the infrastructure policies, and exclusively focus on municipal financings that promote equity, the environment and/or the economy in the communities in which we invest.