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Fixed-Income Insights

Here’s a review of potential implications for municipal-bond investors from proposed U.S. tax-reform legislation.

 

In Brief

  • In our view, pricing pressure on municipal bonds induced by proposed tax-reform legislation in the U.S. House and Senate will be transitory, and likely could present buying opportunities.
  • Neither the House nor the Senate tax proposals threaten the tax exemption of municipal-bond interest.
  • A proposed reduction in corporate tax rates may lower demand for munis from banks and property/casualty insurers.
  • However, an elimination of state and local tax deductions under the proposed bills may increase demand from individuals.
  • Amid uncertainty around the final shape of the legislation, private-activity bond and advance refunding issuance is being rushed to market late in the current year.
  • The key takeaway: We think investors should focus on these facts: overall municipal market credit quality remains stable, demand is strong, and the municipal tax exemption doesn’t seem to be at risk.

 

Concerns about the effect of proposed U.S. tax-reform legislation on the municipal-bond market have weighed on the asset class, with the benchmark Bloomberg Barclays Municipal Bond Index down 0.85% month to date through November 28.  This pressure, however, has not been caused by outflows from municipal-bond mutual funds. Fund flows have continued to be positive over the last couple of weeks, even though the market has been trading down. According to Lipper, municipal mutual funds have seen $659 million in net inflows through November 22, increasing aggregate inflows to $17.8 billion year to date.

So, what is the source of volatility? An uptick in supply induced by certain provisions of House and Senate tax proposals currently in process (as we shall see below).

Although there is still much uncertainty around what the final tax bill will look like—and when, exactly, it will be implemented—our view of five important aspects of the tax legislation and the bill’s potential effect on municipal bonds are outlined below.

1. It is important to note that neither the House nor the Senate tax proposals threaten the tax exemption of municipal-bond interest. Regardless of the final shape of the legislation, municipal bonds should maintain their status as an attractive source of tax-free income.

2. The Senate’s proposal to eliminate the state and local tax deduction from federal taxable income, in our view, would ultimately create even greater demand for municipal bonds issued by high-tax states, such as California and New York, as taxpayers in those states look for alternative ways to minimize federal tax outlays.

3. Both the House and Senate versions of the bill aim to eliminate an issuer’s ability to advance refund existing debt. In addition, the House bill is proposing an elimination of the tax exemption associated with private-activity bonds (PABs), which are bonds issued by private, and some public, entities on a tax-exempt basis for qualified projects and include healthcare, transportation, and education projects, among others. This means institutions such as hospitals, universities, and airports would need to use higher taxable borrowing rates to finance their projects in the future, which likely would lead to higher costs for their services. Despite the uncertainty as to whether or not these proposals will become law, issuers are rushing to market in the last weeks of the year to ensure that they can take advantage of their ability to advance refund or borrow tax-free while they still can.

The current price weakness due to increased supply is expected to be transitory, and likely will present investment opportunities, in our view. First, assuming the bill does pass in its current form, municipal-bond yields are likely to rise above comparable maturity Treasury yields over the short term, potentially attracting crossover buyers (i.e., those who do not typically participate in the muni market) to close the gap, as they have done in the past. Second, in January, the market is likely to see a positive supply/demand dynamic. Why? On the demand side, many bonds will pay their semiannual coupons (note that January 1 is one of the largest days for coupon payment for the year), leading holders to reinvest proceeds the muni market. In terms of supply, seasonal factors may come into play. January, which typically is a thin month for muni issuance, should be even leaner in 2018, as issuance scheduled for early next year is being pulled forward to December of this year.

4. Both current House and Senate proposals call for the repeal of the alternative minimum tax (AMT). Correspondingly, we may see further tightening of yield spreads on municipal bonds whose interest income is subject to AMT, with yields coming more in line with those that are not. This ultimately means AMT bonds may perform well.

5. There is a possibility that the value of the tax benefit from muni bonds may be reduced with a decrease in tax rates. Modestly lower personal income tax rates, in our view, should not significantly change the retail investor’s appetite for municipal bonds. Those whose behavior may be most affected are banks and property/casualty insurers, which are institutional muni investors with relatively high effective tax rates. Although they might not sell their municipal holdings in response to lower tax rates, these institutions might let bonds roll off their balance sheets when they mature or are called, and purchase less in the future if corporate tax rates fall to 20%.

Still, these buyers have a lot of long-term liabilities that match well with the maturity makeup of the municipal bond market compared to other markets, and they have been attracted by munis’ overall strong credit quality, so we would expect that they would remain active participants.  There have been times in the past when institutions have been less of a presence in the market—for example, insurers may reduce muni purchases when their profitability has been hurt by large claims paying events—and yet the municipal bond market has functioned well in spite of their reduced participation.

Summing Up
Whether or not the proposals abovementioned are contained in a final bill signed into law by President Trump, issuers must react as if these proposals will become reality. What likely would be the short-term result? There would be pricing pressure from increased supply. This, in our view, should introduce buying opportunities as crossover buyers step in and supply thins out next year. Over the longer term, although lower corporate tax rates may pose a headwind to demand from institutions, retail demand is expected to increase if state and local tax deductions are eliminated. Overall, the supply of tax-free bonds would shrink with the elimination of private-activity bonds and advance refunded offerings, creating scarcity value in munis. Of course, all these developments will give muni investors plenty to consider in the weeks to come. However, the proposals are not set in stone, and there likely will be significant changes to the tax bill before it becomes law.

Here, we think it might be useful to mention historical research we’ve highlighted before showing that past changes in the top marginal tax rate have not had a significant impact on the market. According to a report from Citi Research, the top marginal tax rates for municipal bonds fluctuated in the range of 28–70% between 1980 and December 2016. But the report found no correlation between municipal yields and the top marginal tax rate. This is likely because the average tax rate for municipal bondholders has remained steady, at around 25%, during the period surveyed. [Results may have differed during different intervals in the survey period.]

In the meantime, we advise that investors focus on what they do know: despite increased supply over the next few weeks, overall municipal market credit quality remains stable, demand is strong, and the municipal tax exemption doesn’t seem to be at risk. The aforementioned market dynamics further highlight the value of engaging with professional active managers with deep municipal market expertise.

 

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About The Author

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The Lord Abbett Intermediate Tax Free mutual fund seeks to deliver a high level of income exempt from federal taxation. View portfolio and performance.
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The Lord Abbett High Yield Municipal Bond mutual fund seeks to deliver income exempt from federal income tax by investing in lower-rated municipal bonds.
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