MuniLand: The Municipal Sector that Won’t be Impacted by Tax Reform…Because it is Already Taxed

When is your municipal bond income taxed? Well, when it is a taxable municipal bond. Despite appearances, this is not silly joke. Large and small entities, from states, colleges, towns and cities to essential service agencies, can and do issue taxable debt. There are many reasons why issuing taxable debt versus tax-exempt debt can be beneficial. One is the American Recovery and Reinvestment Act of 2009. The law provides a special tax credit or federal subsidies to either the bond holder or issuer. Another reason a municipal entity may issue taxable debt is because a project may not meet the criteria of providing a major public benefit, which is the hurdle for issuing tax-exempt debt. Finally, tax-exempt bonds may only be advance refunded once. Advanced refunding is a finance technique that allows the debtor to benefit from lower interest rates when the outstanding debt is not currently callable. If the interest rate environment is favorable, then the debtor can further reduce its cost of capital by refinancing the advance refunded bond as taxable debt. Given that rates have fallen over the last few years, in certain cases municipalities can realize cost savings from multiple refundings, even if the newly issued bonds are taxable. 

The taxable municipal market is a niche market, one that we at SNWAM are fond of. With good security selection, taxable municipal bonds can provide better volatility-adjusted returns relative to other sectors of the taxable market, such as corporate bonds. In addition, taxable municipal bonds can also have more stable credit profiles, as is often the case with large private or public higher education names or large multi-state hospital systems. Relative value opportunities in the taxable municipal market can be few and far between, but we are expecting some potential market disruption in the coming months. The Bloomberg Barclays U.S. Taxable Municipal Index, which is part of the larger U.S. Aggregate Bond Index, will undergo an important change at the end of March. The index rules are changing, which will increase the minimum bond size (as measured by amount outstanding) to $300 million from $250 million. This change also will impact Treasury, government related and corporate bonds in the “Agg”. As a result, some 125 of the 299 bonds in the taxable municipal index will drop out, potentially creating a buying opportunity because index funds and other investors that closely track the taxable muni index will be forced sellers. As a separate account manager, our portfolio sizes, highly risk-aware portfolio management, credit analysis and nimble trading tools position us well to take advantage of the index recomposition event.

Source: Bloomberg, Barclays and SNWAM Research