We don’t mean to start off the market note too darkly this week, but we feel that updating this famous quote, attributed to Benjamin Franklin in 1789, is appropriate more than two centuries later as we analyze the current political and financial climate. With President Elect Trump set to be sworn into office next week, we have been busy analyzing some of his, and the Republican controlled Congress’s, ideas around stimulating the U.S. economy. We wrote last week about the broad bond market outlook. This week we focus on tax policy, which is on the top of the agenda for the new administration, and on its potential impacts on the municipal bond market.
While some form of tax policy change is likely in 2017, the mechanics behind implementing these reforms are highly uncertain. To simplify the analysis, we have broken down the moving parts into four groups: the tax-exempt status of municipal interest, the impact of a reduction in personal income tax rates, the impact of a reduction in corporate tax rates and the impact of a reduction on other forms of interest.
Tax-Exempt Status of Municipal Interest
We think it is unlikely that the municipal bond interest exemption will be eliminated. This view is consistent with comments President Elect Trump made when speaking to the Conference of Mayors in late December. Eliminating the tax-exempt status would also directly raise the cost of borrowing for municipalities, the entities most likely to enact the fiscal infrastructure related spending plans that the new administration has discussed.
Personal Tax Rates
It is likely that personal tax rates will be lowered in 2017. Historically, there is precedence for this scenario, most notably in the 80s under the Reagan tax cuts and the early 2000s under the Bush tax cuts. As can be seen in the charts below, a reduction in personal tax rates is unlikely to have a meaningful impact on the muni market.
Municipal bond flows tend to be driven by rate movements, not personal tax rates. This is likely the reason that municipals underperformed in the fourth quarter, as interest rates moved sharply higher.
Corporate Tax Rates
A reduction in corporate tax rates has the potential to be a negative for the municipal market. Corporate tax rates in the 15% to 20% range, as have been discussed, would reduce the attractiveness of tax exempt bonds to banks and some insurance companies with higher effective tax rates. Banks and insurance companies represent the marginal buyer of municipal bonds and hold about 28% of all municipal market debt. The chart below details the holders of municipal bonds since 2004. Note that banks (purple line) have been steadily increasing their holdings over the past five years.
In a recent survey, Citigroup asked 78 of their corporate clients questions regarding their municipal purchases under different tax rates. The responses are below:
It is unlikely that banks and insurance companies would immediately sell their municipal holdings in a lower tax rate environment, but the market could lose an important source of demand.
A Reduction in Other Forms of Interest
The most disruptive proposal that we have seen comes from the House GOP tax reform blueprint, which would give taxable investment interest the same treatment that long-term capital gains now receive. The blueprint’s proposal would tax interest at half the top marginal rate, or 16.5% (assuming the top personal rate gets changed to 33%). In this scenario, municipal yields would likely rise in order to provide an equivalent return to taxable bonds for top-bracket investors. According to the Wall Street Journal, this proposal is tied to a package that includes the removal of interest deductions for businesses, which is facing significant pushback from the business community.
What Might Be the Impact on the Market?
Ultimately, we estimate the impact from tax law change on the muni market will range from a 0 to 50 basis point correction higher in muni yields. Given the high degree of uncertainty about what a tax reform package will ultimately look like, we felt it prudent to develop a base case scenario, where the average personal tax rate drops to 30% and the corporate tax rate drops to 20%, with no change to the tax-exempt status of munis or the tax treatment of taxable interest income. In this scenario, we estimate 10 year muni yields would rise by up to 30 basis points.
What Should I Do?
At this stage, given all of the aforementioned uncertainty, we are not recommending our clients shift away from an all municipal portfolio. Municipals offer many positive characteristics, such as high credit quality, low volatility, and, for investors in high income tax states such as California, exemption from state income taxes. In addition, our fundamental credit outlook for the municipal market is positive and supply is expected to drop significantly this year, which creates a positive technical backdrop.
However, if you are concerned about the potential impacts from tax reform and wish to hedge your portfolio from these impacts, our Blend Strategy, which includes corporate, treasury/agency and taxable municipal bonds, may be an appropriate alternative. Our current allocation target is 65% tax-free municipal and 35% taxable bonds, which would likely outperform an all municipal portfolio in the short term in a downside scenario resulting from tax reform.
Source: Citigroup, Federal Reserve, JP Morgan, SNWAM Research, Wall Street Journal