The municipal bond market was a bit schizophrenic as the debate over the tax bill reached the final stages late last year. While several proposals could have considerably changed the market, the most negative, fortunately, were not enacted. But those that were could alter the muni market. How will they impact muni returns in the years ahead?
MUNI BONDS—A PRIMER
Before we discuss the tax bill, let’s briefly review the municipal bond market. Munis are offered by state and local governments to fund infrastructure projects. They offer the same attractive features as taxable corporate or government bonds, with one difference that is also munis’ defining trait: Munis are generally tax-exempt. In essence, investors can often receive a higher net yield after taxes when buying tax-exempt municipal bonds compared with taxable bonds, with lower default and interest-rate risk.
THE PULL FORWARD
Ambiguity surrounding which of the proposals the final tax bill would adopt created a lot of angst for issuers and caused tax-exempt entities to issue a greater than normal number of bonds in the fourth quarter. In fact, December saw the largest month of supply on record. Demand for these bonds, though, was strong, keeping prices from falling amid the new supply glut. However, this pull forward in supply will likely reduce issuances in 2018.
The final bill contained three important changes that have potential consequences for the muni market. First, it eliminated advanced refunding bonds. These bonds are issued to lock in lower borrowing costs before issuers can retire previously issued bonds, either through calling the bonds or at maturity. Think of it this way: When you own a mortgage, unless you have a prepayment penalty, you can decide to refinance that mortgage at a lower interest rate at any time, racking up significant savings over the life of your loan. The Tax Cuts and Jobs Act of 2017 essentially removed that option for issuers. Why does it matter?
Advanced refunding represented roughly 16% of bond issuances in the market over the last 10 years. A direct consequence of this provision should be a reduction in the number of muni bonds that are sold into the market. Simple economics suggests that reduced supply with no change in demand will drive prices higher. This provision should be supportive of the market in the near term—a win.
In addition to eliminating advanced refunding, the tax bill also reduced the corporate tax rate to 21%. Approximately one-third of munis are owned by companies, predominately insurance companies and banks, who have historically paid an average blended tax rate of approximately 28%. At the new tax rate of 21%, they will receive less benefit from owning tax-exempt bonds relative to corporates or treasuries. Let’s examine this further.
Last year, a corporation that was considering buying a tax-exempt municipal bond with a yield of 3.2% or a taxable bond with a yield of 4.5% would have been indifferent (assuming everything else is equal), since, on an after-tax basis, their yields are the same (3.2%) (Display 1). This year, however, using a corporate rate of 21%, the after-tax yield on that same corporate bond is now higher, at 3.6%. We believe that corporations will not sell their existing municipal bond holdings in the near term. Instead, we expect these companies to shift their asset allocation away from muni bonds over time, so that longer term, they will own fewer munis. This shift will result in lower demand for munis—a loss.
…AND A PUSH
Individuals own the other two-thirds of outstanding municipal bonds. Their tax rates were also lowered in the tax bill. Will these reductions have a similar impact on the muni market, as the reduced corporate rate may?
We don’t think so. Individuals in the top brackets tend to be the primary buyers of tax-exempt municipal bonds. Although the rate has been reduced, the highest moving from 39.6% to 37%, it is only marginally lower. Tax-exempt bonds still make sense at these high tax levels relative to other bond investments—a push.
OVERALL NET NEUTRAL
We see the tax bill legislation as a net neutral for the muni market. The reduced supply from eliminating advanced refunding will be somewhat offset by reduced demand as some corporations no longer find tax-exempt muni bonds attractive relative to taxable bonds. But these changes should have a minimal lasting impact on the muni market as the majority of buyers— individuals—continue to demand these tax-free instruments.
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The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.