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Fixed-Income Insights

Herein we assess the potential short- and long-term effects of the legislation on the municipal market.

 

In Brief

  • We believe that the relative value of the municipal bond market remains strong for 2018, while there are several indicators to follow in order to understand longer-term trends.
  • Individual demand should stay strong since the municipal bond tax exemption remains, and could become stronger, because there will be fewer alternative ways to receive tax deductions.
  • Corporate demand will decrease, but the amount of the reduction is uncertain. 
  • Supply should be lower during the beginning of 2018 due to the heavy supply during the final months of 2017. 
  • For a few years, the market will face lower supply, with advanced refundings eliminated. 
  • With the changes in the SALT deduction, state and local issuers will need to be watched for population shifts and changes in revenues, but these will be long-term trends to monitor, which should have only mild impacts. 

 

Ever since President Trump was elected, one of the Republican Party’s primary goals has been to change the tax code. Although the municipal bond market has not been an area of focus, there have been concerns about how it would be affected. Now that the Tax Cuts and Jobs Act has been enacted, focus can pivot away from speculation and toward considering what the actual impact of the bill might be. Overall, the municipal bond market has avoided the major initial concerns of investors, but there will be an impact. Following are five changes to consider when contemplating the outlook for the municipal bond market:

1) Reduction in Tax-Exemption Alternatives
The first impact, and definitely a positive one, is that while many tax exemptions are going away or are being capped, the municipal bond interest tax exemption is staying. Because there are now fewer tax-exempt investment alternatives, we expect demand for municipal bonds to increase. Some of the deductions that have changed 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. 

2)  Elimination of Advanced-Refunding Bonds
Second, municipal bond issuers will no longer be able to complete advanced refundings of their 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. The adjustment took market participants by surprise when it first appeared in the House bill, and it remained in the final compromise. Most observers were dismayed that refunding  bonds had become a focus of the tax bill, because there hadn’t been much discussion about them in Washington. 

For those not familiar with the sector, an advanced-refunding bond is created when an issuer wants to refinance an outstanding bond at lower interest rates prior to a bond's actual call date. Since the previous tax reform act, issuers have been allowed to advance refund some bonds one time after their initial issuance. When a bond is advanced refunded, an escrow account of securities (typically U.S. Treasury bonds) is created as the security for the original bonds until their call date and a new bond backed by the issuer is created. This means that the original bonds become high-quality investments, with the call date becoming the maturity date that makes them short bonds. Also, until the bond’s original call date, both bonds remain outstanding. The pre-refunded sector is a large portion of the short municipal bond market. For example, the Bloomberg Barclays Short 1 to 5 Year Index has a 27% weighting in pre-refunded bonds, as of December 26, 2017.

It is difficult to understand why advanced-refunding bonds were eliminated because their primary benefit has been to lower interest payments for issuers, which, in turn, allowed them to lower expenses in their budgets. The reason could be that there are two tax-exempt bonds outstanding for a while. One set of investors gets the security and the coupons of Treasury bonds as tax-exempt interest with pre-refunded bonds, and so Congress might think that it can raise some small amount of revenue by eliminating these bonds and hope that people will use their money to buy bonds with taxable interest, thus creating more income to be taxed. 

Still, whatever the reason, a large portion of municipal bond issuance will go away over the next few years, and a very popular sector of the market for risk-adverse individual investors will eventually disappear. 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 will likely 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 will want shorter calls, such as five years, instead of the current standard of 10 years, because they will 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, but require more interest to be paid each year as an offset. Also, buyers will not put as much value on premium coupon bonds, since the advanced refunding option would not be available, so the cost of borrowing for issuers could increase.

3) Lower Corporate Tax Rates
The third impact of the tax bill is lowering the corporate tax rate. While municipal bond market demand is dominated by individuals either through professionally managed products or brokerage accounts, corporations represent approximately one quarter of municipal bondholders. The primary types of corporations that own municipal bonds are commercial banks and insurance companies. With the corporate tax rate dropping, from 35% to 21%, the benefit of their holding 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 them without demand for long periods of time; but this time, the calculations will be different. Insurance companies should still like 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, this is a negative for the market but tough to quantify.

4) Impact of Cap on SALT Deductions
The fourth impact—and this is an uncertain one that could be a negative in the long term—is the impact of the cap on SALT deductions on state and local governments. Without this deduction, the cost of living could go up in higher-tax states. This is because overall tax burdens could increase without the deduction. Also, 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 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. 

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, and because of the 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 rather than the short term, and might not be too material, but they still need to be watched.

5) Heavy 2017 Year-End Supply
A fifth impact for 2018 that is a positive for the market is what did not stay in the final bill, and that was the possible elimination of private-activity bonds. For a few weeks, there was concern because the House bill had included elimination of these types of bonds, which represented approximately one-third of new municipal bonds issued, including sectors such as industrials, healthcare, education, and transportation. 

The reason this is important, even though it is not in the bill, is because there was a record amount of new bonds issued for a December. Issuers brought 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 issuance was also due to a lot of advanced refundings that would 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, so new bond issuance is expected to be on the very light side during the beginning of 2018. This could provide an attractive performance environment, with demand remaining the same, but supply falling materially.

Summary
Overall, the tax bill contains pluses and minuses, but the end result is not too dramatic for the long term.  Individual demand should stay strong since the tax exemption remains and could become stronger because there will be fewer alternative ways to receive tax deductions. Corporate demand will decrease, but the amount of the reduction is uncertain. Supply should be lower during the beginning of 2018 due to the heavy supply during the final months of 2017. Also, 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 changes in revenues, but these will be long-term trends to monitor, which should only have mild impacts. So, we believe that the relative value of the municipal bond market remains strong for 2018, while there are several indicators to follow in order to understand longer-term trends.

 

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Lower-rated investments may be subject to greater price volatility than higher-rated investments. A portion of the income derived from a municipal bond may be subject to the alternative minimum tax. Any capital gains realized may be subject to taxation. Investments in Puerto Rico and other territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The information provided is for general informational purposes only. References to any specific securities, sectors or investment themes are for illustrative purposes only and should not be considered an individualized recommendation or personalized investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a reliable indicator of future results.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

No investing strategy can overcome all market volatility or guarantee future results.

The Bloomberg Barclays Municipal Managed Money Short (1-5 Year) Index is a component of the Bloomberg Barclays Managed Money Index, which is rules-based, market-value-weighted index engineered for the tax-exempt municipal bond market.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education.  None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity.   If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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