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Fixed-Income Insights

Investors have fretted about the prospect of higher interest rates, along with uncertainties about tax policy and infrastructure spending. Here, we put those concerns into context. 

 

In Brief

  • In recent weeks, municipal bond investors have had to contend not only with rising interest rates but also with a number of concerns related to potential policy initiatives under newly elected U.S. president Donald Trump.
  • These concerns include potential changes to U.S. personal and corporate tax rates; the continued tax-exempt status of municipal bonds; the size of, and method of financing for, Trump’s promised increase in infrastructure spending; and the effect of planned U.S. fiscal stimulus on interest rates and inflation.
  • While these worries have contributed to recent weakness in the municipal-bond market, investors may wish to consider the following points as the new year approaches:

            1) Tax-equivalent yields on muni bonds remain attractive.
            2) The percentage of muni investors affected by tax bracket changes is rather low.
            3) Munis historically have weathered rising tax rates rather well.
            4) The large recent increase in U.S. interest rates may be nearing its end.

  • The key takeaway: The muni market’s initial reaction to a Trump administration has been negative, but the outlook could change as policy and market developments in 2017 are more thoroughly analyzed.

 

Since Donald Trump won the U.S. presidential election on November 8, investors have been adjusting to a materially different environment.  In the U.S. fixed-income markets, interest rates are higher across all maturities, and many factors that have been driving expectations for future market movements have radically changed. 

For municipal bond investors, there are other issues to consider than only the direction of interest rates. The election of Trump and Republican majorities in both houses of the U.S. Congress raises some significant questions about changes to tax policy, the type of financing that will be proposed to provide a promised boost to infrastructure spending, and how Trump’s fiscal plans will influence economic growth and inflation.

It has been a while since U.S. government policy has been poised for such dramatic changes, so investors should pay heed to these issues carefully.  We’ve identified some of the concerns that might be at the top of the list.

Tax Rates
Compared with other fixed-income categories, the unique and most important issue for municipal bonds from a relative-value standpoint is the potential for changes in U.S. tax policy. The possibilities include adjustments to corporate and personal tax rates or changes regarding the exemption of municipal bond interest from federal taxation.  Since both President-elect Trump and the Republican leadership in Congress strongly favor lowering the higher income tax rates, it is probable that a change will occur.  The most likely outcome appears to be legislation lowering the highest individual tax bracket, from 39.6% to 33%.  While this is lower than the current highest bracket, it should not have a major long-term impact on the municipal bond market because of two potentially mitigating factors. 

First, according to information from the Internal Revenue Service, less than 20% of the municipal bond income declared on U.S. tax returns was made by filers in brackets above 33%.  Surprisingly, then, most municipal bond investors would not be affected by this bracket change.  Second, tax-equivalent yields are still very attractive, in our opinion, at a 33% or even a 28% bracket.  For example, for someone in a 40% tax bracket, a 3% municipal bond yield leads to a tax-equivalent yield of 5%.  This means that an investor would need to find a taxable investment with a 5% yield to have the same aftertax return.  For someone in a 33% tax bracket, the tax-equivalent yield for a 3% investment is still 4.48%.  In a 28% tax bracket, the tax-equivalent yield is 4.17%. 

Considering that a 30-year U.S. Treasury bond yielded 2.99%, as of November 29, according to Bloomberg, it would be very difficult to match the tax-equivalent yield of a high-grade municipal bond with a taxable bond that has anywhere near the same credit quality.  So, while a reduction in the highest U.S. income tax bracket may be somewhat negative for muni bonds overall, it should not represent a significant change for investors.

Munis’ Tax-Exempt Status
Still, the tax situation could become more complicated under the new administration.  As we mentioned earlier, there is momentum to lower corporate income tax rates.  If they are reduced, there may be a lessening in demand for municipal securities from institutional investors.  For example, while the insurance industry isn’t a huge presence in the overall municipal bond market, property-casualty and life insurance companies do have significant muni holdings in their portfolios.  If corporate tax rates decrease, it is possible that these companies would want to pare their municipal bond holdings.  These companies would still find municipals attractive for liability matching and diversification, but the breakeven yields for relative value, compared to taxable bonds, would be higher.

Another potentially negative outcome for the market would be if the exemption for municipal bond interest is eliminated altogether.  While this seems very unlikely, given the benefits to all levels of society from the low borrowing rates for muni-bond issuers, it could be on the table if the incoming administration is looking for a radical change to the tax code.  Eliminating the municipal bond-interest exemption from taxation has been raised several times in the past, but the idea has never gained much traction, given that the greatest beneficiaries from munis’ tax-advantaged status are not well-off investors but issuers such as state and local governments, schools, hospitals, and water districts that benefit from lower borrowing costs. 

That last point is especially important. Many assume only high-income investors benefit from allowing municipalities to have lower borrowing rates, but in reality it helps people in all income levels. This is because if municipal bond interest becomes taxable, it would cost more for governments and related entities to borrow for such outlays as capital expenditures. Without muni bonds, infrastructure needs would have to be financed in a different, higher-cost way; those increased costs would be passed on to all consumers.  Higher borrowing rates would cause all kinds of fees to be raised for such essential services as water, sewer, and transportation systems.  In recent years, mayors and governors have done well organizing and voicing their concerns to make sure that members of Congress understand the situation, so it is likely that those methods would be used again.  We consider elimination of the exemption to be a very low-probability outcome in a Trump administration.

Market Reaction to Lower Tax Rates
How might the municipal bond market react to lower income-tax brackets?  The best way to analyze this is to look at what happened the last time, during 2001–01, that a Republican president, in this case George W. Bush, was elected to succeed a Democratic president, Bill Clinton, with a fiscal plan that included reducing taxes.   

A good way to observe the impact is to compare the ratio of municipal bond yields to Treasury yields.  If there had been excessive concern about the impact of lower tax rates, the ratio would have risen, because municipal bonds yields would have risen more than Treasury yields, leading to underperformance.  The ratio of 30-year maturities is typically the most volatile and has a higher yield ratio compared to those of shorter maturities. 

During 2000, the ratio of Municipal Market Data’s (MMD) ‘AAA’ rated municipal bond yield to 30-year U.S. Treasuries averaged 96%.  Over the second half of the year, when President Bush was elected, the ratio stayed around an average of 96%.  In 2001, when tax rates were first lowered, the ratio dropped to an average of 93% during the first half of the year and then moved to a 94% average over the second half.  This means that municipal bonds outperformed Treasuries while tax rates were falling.  During 2002, the ratio rose, and municipal bonds underperformed, but then during 2003, the ratio fell below 96% again. 

In 2006, which was during President Bush’s second term, the ratio fell below 90%.  So, even though income tax rates had been lowered, municipal bonds did not underperform.  Significant municipal bond market underperformance did not occur until 2008, but that was due to the credit crisis rather than issues related to tax rates.

Infrastructure Plan
Now moving on from tax rates, another issue municipal bond investors are focusing upon is President-elect Trump’s infrastructure plan.  The major concern is how the potential projects will be financed.  Currently, a significant portion of the infrastructure needs in the United States are financed through the municipal bond market.  For example, during the recent election, voters approved a large number of future municipal bond issues that are likely to come to the market during upcoming years to upgrade areas such as roads and schools. 

Trump’s plan is not clear, but he has stated that he wants a lot of infrastructure spending to stimulate the economy.  These plans need to be approved by Congress, so they are likely to become smaller, given the fiscally conservative approach by congressional leadership in recent years.  With tax-rate reductions likely, an off-the-chart amount for infrastructure spending is unlikely, unless projections of revenue increases are realized quickly.

Assuming an infrastructure plan gets approved, muni investors are questioning whether it would lead to a large increase in municipal bond supply.  While this could be positive for some muni-bond players, such as underwriters and public finance bankers, excess supply could put pressure on the overall market while it finds enough demand to absorb the supply.  Still, it is unclear if ramped-up muni issuance is a likely possibility, because Trump has discussed many other forms of financing.  These possible plans have included public/private partnerships, tax credits, and grants.  It is unclear whether the municipal bond market will be used at all. 

The issue of infrastructure finance is something to watch in the months to come.  The most likely outcome is to have some additional supply to supplement other forms of funding, but not a dramatic increase that would have a long-term dampening effect on the market.

Fiscal Stimulus
The sharp interest rate increases in all fixed-income markets in the wake of Trump’s election shows that investors in all corners of the fixed-income market have concerns, mainly about the sheer scope of fiscal stimulus under the new administration.  Some observers are projecting that this could lead to sharp increases in economic growth and rising inflation.  Also, the stimulus might need to be financed through borrowing until the projection of increased tax revenues occur.  This might lead to heavy Treasury bond issuance and put pressure on Treasury rates.  Since most fixed-income markets move in the same direction as Treasuries, this also could weigh on municipal bond prices. 

But thanks to factors outside the United States, there likely will be a limit on how much U.S. rates can rise. Let’s, for example, look at the global backdrop. Economic growth is very slow around the world, including in Europe and Japan, and there are no significant signs of inflation on the horizon. Meanwhile, central bank actions that try to increase anemic economic growth have not had much success.  Given the wide spread of yields on U.S. fixed income to those in Europe, it is likely that we are not far from a cap on U.S. rates. (That’s attributable to the likelihood that non-U.S. rates will remain low.) Of course, there are no guarantees, but the post-election market reaction in terms of U.S. bond yields just seems like it might be a little too much, too soon right now. It will take some time for investors to fully understand the shape of any potential fiscal changes in the United States, and to think through their impact carefully.

Summing Up
While there are many less-momentous factors to consider, the market concerns listed herein have occupied investors’ thoughts during the challenging environment for municipals since Trump was elected. Based upon the large outflows from municipal bond mutual funds in recent weeks, including the more than $3 billion that left the market during the week after the election, many investors are concerned about some or all of these issues. 

But perhaps they’re carrying things a bit too far. As we’ve noted:

  • Tax-equivalent yields remain attractive.
  • The percentage of muni investors affected by tax bracket changes is rather low.
  • Munis historically have weathered rising tax rates rather well.
  • The large recent increase in U.S. interest rates may be nearing its end.

It is likely that investors may be reacting to potential changes in the muni environment without a complete analysis.  Some might be taking gains in the face of uncertainty because municipals have performed so well in recent years.  These investors’ actions might suggest that they are putting a larger risk premium on the market due to the uncertainty of various scenarios for the muni sector, but it is possible that they might be overly pessimistic about future outcomes. 

When municipal bond rates were more than a full percent lower back in July, there were large flows into municipal bond mutual funds. With rates much higher now, we think it is likely that after the current volatility, investors will recognize that the asset class looks relatively attractive and that outcomes for the policy and economic issues that keep them awake at night might not be so negative after all. 

 

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