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Fixed-Income Insights

What are the possible short- and long-term effects of the legislation on the municipal market? Here is our view.

Note: This article is from the forthcoming issue of The Muni Quarterly.

Ever since the initial discussions about the U.S. Tax Cuts and Jobs Act, there have been concerns about how the municipal bond market might be affected by the legislation.  Now that the legislation was passed in December 2017, and is being implemented, it is clear that the municipal bond market has avoided the negative consequences initially feared by investors. Still, the bill is in its early days, so as time progresses, investors will need to assess the changes and keep track of the effects of the legislation.

We at Lord Abbett have been following the situation closely. What follows are changes to consider when contemplating the outlook for the broad municipal bond market—and several key sectors that could be affected.

Broad Municipal Bond Market Impacts
Fewer tax-exemption alternatives—While many tax exemptions are going away or are being capped, the municipal bond-interest tax exemption is staying. Further, because there are now fewer tax-exemption alternatives, we expect demand for municipal bonds to remain strong. Some of the deductions that have changed under the new tax code include the cap on state and local tax (SALT) exemptions, the increased standard deduction reducing the benefits of charitable deductions for some, and the reduced cap for mortgages qualifying for full exemptions. The cap on SALT deductions should support the municipal bond market, especially for investors in higher-tax states, such as California and New York. 

Elimination of advanced-refunding bonds—Municipal bond issuers are no longer able to complete advanced refundings of their outstanding bonds. This change eliminates some of the new-issue supply for the next few years, and eventually will remove a large sector of the market.

For those not familiar with the sector, an advanced-refunding bond is created when an issuer refinances an outstanding bond at lower interest rates prior to a bond's actual call date. Since the previous tax reform act in 1986, issuers have been allowed to advance-refund some bonds one time after their initial issuance.  This action creates two bonds outstanding until the original bond’s call date: a new bond supported by the issuer and a pre-refunded bond typically backed by U.S. Treasuries, which matures by the call date of the original bond.

During 2016, 29% of the municipal bond market’s new-issue volume was composed of advanced refunding deals, according to Bloomberg. Municipal bonds can still be refinanced at their call dates rather than in advance, so overall issuance likely will be lower over the next few years, until bonds that have not been advanced-refunded reach their call dates.

In addition to these changes, the bill also likely will lead to differences in the structures of new municipal bond issues. Since advanced refunding will not be an option, some issuers may want shorter calls, such as five years, instead of the current standard of 10 years, because they might want flexibility if yields move lower. Issuers also might not issue as many premium coupons, because these bonds have been used as more attractive candidates for advanced refundings and, therefore, helped them to keep their borrowing costs lower. Also, buyers might not put as much value on premium coupon bonds, since the advanced-refunding option would not be available.

Lower corporate tax rates—While municipal bond market demand is dominated by individuals, either through professionally managed products or bond holdings in brokerage accounts, corporations represent approximately one quarter of municipal bondholders. The main participants in this segment are commercial banks and insurance companies. With the corporate tax rate dropping, from 35% to 21%, the benefit for corporations of investing in munis will shrink.

It is tough to quantify how much, but it will be different. Over the years, property and casualty insurance companies have been in and out of the market, as their profitability has fluctuated with natural disasters, so the market has dealt with insurers’ reduced participation for long periods of time; but this time, the calculations will be different. Insurance companies should still like the strong credit quality, along with the longer average maturities of municipal bonds compared to other markets, which fits well with the length of their liabilities, but they may need higher yields to participate. So, while this is a negative for the market, it will be difficult to gauge the ultimate impact.  On the positive side, there are some new tax benefits for life insurance companies, so, we believe, their participation should increase.  With supply expected to be low this year, potential reduced demand from corporations should not have a material impact on the market, unless these holders decide to sell extremely large portions of their existing portfolios—but we think that is unlikely.

Heavy 2017 year-end supply—One impact that is already happening due to the tax bill is a positive for the market, due to what did not stay in the final bill: the possible elimination of private-activity bonds. For a few weeks, there was concern, because the House version of the bill had included elimination of these types of bonds, which represented approximately one-third of new municipal bonds issued, including sectors such as industrial development, health care, education, and transportation.

The reason this omission is important is because there was a record amount of new bonds issued during December 2017. Issuers brought forward a number of bond deals because they were not sure if they were going to be able to issue in the municipal bond market in the future. The December issuance also was due to a lot of advanced refundings that will not be possible to complete in the future. As a result, many bonds that would have been issued during the first quarter of 2018 were moved into December 2017. Thus, new-bond issuance has been on the very light side during the first few months of 2018. For example, January 2018 was a very low supply month, with less than $20 billion of bonds issued, compared with more than $60 billion in December 2017.  This is providing an attractive relative performance environment, with demand remaining similar, but supply falling materially.

Individual Sector Impacts
Local government—The capped SALT deduction will result in an increased effective tax burdens for higher-income taxpayers who itemize their federal tax deductions in high-tax states. These states include California, Connecticut, Illinois, Maryland, Massachusetts, New Jersey, and New York.  Many of these states have higher costs of housing, and with a more limited mortgage deduction, tax liabilities could go up, thereby reducing the value of the underlying real estate. Even for those who don’t have mortgages that size them out of the exemption, the increased personal exemptions could make the mortgage deduction unnecessary, which could reduce the value of their real estate. 

Many local governments in these states are already contending with large, unfunded pension liabilities and deferred capital expenditures. For those entities that are property tax-dependent, their revenue-raising ability may be constrained, and they could find it politically difficult to increase property tax rates, even if they had authorization to do so. Still, these are long-term issues, and municipalities should have plenty of time to adjust. We will keep an eye on this developing situation. 

At the state level, there are different concerns. Both California and New York are considering counter measures at the state level that could help taxpayers avoid the SALT cap. In California, for example, there is a proposal to make state and local taxes charitable donations, which are fully deductible. New York is considering a statewide payroll tax on employers, which is deductible on employer federal taxes, in place of the employee state wage tax. Both proposals are in the preliminary stage, and it is uncertain whether the IRS would deem them to be allowable.

Some analysts are predicting population shifts as some people move from high-tax states to low-tax states to reduce their burden. Many of these projections seem overdone, especially since these states have had higher costs of living for a long time, while still having high demand for housing in many areas, and because of the longer-term demographic shift to urban environments. Still, this issue needs to be watched to see if it causes real estate prices to fall, which would lead to lower taxes and possibly pressure on local government budgets. All of these possible changes would occur in the long term, and might not be too material, but they still need to be monitored.

Higher education—The combination of a cap on SALT deductions and a doubling of the standard deduction will result in fewer filers itemizing deductions on tax returns.  As this removes an incentive for making gifts, charitable giving at colleges and universities may decline. The doubling of the exemption from income taxes for estates likely will have a similar impact. However, it should be noted that people making large gifts most likely will still itemize and not use the standard deduction. This likely would affect private universities more than public ones.

The tax plan also includes a 1.4% tax on investment earnings for private colleges and universities with more than $500,000 of assets per student, although schools with enrollments of fewer than 500 students are excluded. Although the number of institutions affected by this provision is currently limited, this does open the door to possible future increases to the scope or rate of the tax, which could more negatively affect credit quality.

Health care—Included in the tax plan is a provision that repeals the individual insurance mandate of the Affordable Care Act, which required everyone to either have insurance or pay a penalty for not having it.  Therefore, many people currently purchasing health insurance will now have the option to be uninsured.  As healthy people are more likely to go without insurance, the overall health insurance pool is likely to be sicker and more costly on average. Thus, the cost of comprehensive health insurance is likely to rise, even as the number of insured people declines. This likely will result in an increased uninsured population and higher uncompensated care costs, potentially hurting hospital operating margins and cash flow. Hospitals most at risk will be those most reliant on Medicaid, in areas with weak economic conditions, leading to a greater number of payers who lack insurance or have limited financial resources to cover their healthcare costs. There will be a wide range of impact from this change, with many healthcare systems having limited changes, so we will keep monitoring the individual credits in this sector.

Summary
Overall, the tax bill contains pluses and minuses, but the end result should not be too dramatic for the municipal bond market over the long term. Individual demand for muni bonds should stay strong since the tax exemption remains; it could strengthen further, because there will be fewer alternative ways to receive tax deductions. Corporate demand likely will decrease, but the amount of the reduction is uncertain. Supply should be lower during the beginning of 2018, and likely throughout the year, due to the heavy supply during the final months of 2017 and the elimination of advanced refundings. Actually, for a few years, the market will face lower supply, with advanced refundings taken off the table. Eventually, supply should return to its normal levels as outstanding bonds reach their call dates, but that will be over the long term. With the changes in the SALT deduction, state and local issuers will need to be watched for population shifts and revenue changes, but these will be long-term trends to monitor, which should only have mild effects.

The key takeaway here is that we believe that the relative value of the municipal bond market remains strong for 2018, though we note that there are several longer-term trends that need to be watched closely. 

 

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