By: Richard A. Anderson
Certain aspects of the tax bill signed into law at the end of last year have received significant attention from investors, and rightfully so. The final version of the Tax Cuts and Jobs Act lowered corporate tax rates, realigned personal tax rates, and capped or eliminated certain deductions (i.e. state and local tax deductions). These aspects have garnered the majority of headlines in the news and across media publications because they affect most businesses and individuals in some shape or form.
One aspect of the tax bill that has been less-publicized is the impact on municipal bonds. The Tax Cuts and Jobs Act has ramifications for the structure of the municipal bond markets, the credit quality within certain sectors of the municipal bond market and the relative value of municipal bonds as compared to taxable bonds.
What Hasn’t Changed
The good news for municipal bond investors is that the new tax bill did not repeal the municipal bond tax exemption, nor did it repeal the 3.8% tax on net investment income for high-income earners (often referred to as the Obamacare Tax). When the initial tax reform conversations started in late 2017, there was some concern these items could be repealed, which would have made municipal bond interest less attractive relative to taxable bond interest.
In addition, the new tax bill does not eliminate the ability to issue private activity bonds (PABs). Private activity bonds are tax-exempt bonds issued on behalf of a state or local government to provide financing for qualified projects. PABs are often issued by hospitals, nonprofit colleges and universities, and airports. If the ability to issue tax-exempt PABs had been eliminated, issuers who were previously eligible to issue tax-exempt bonds would have to issue taxable bonds instead. Taxable bonds usually carry higher interest rates because their interest is subject to federal and state income taxes, whereas municipal bonds are exempt from federal taxes (state income tax exemption is dependent upon the state). Higher interest costs for issuers would negatively impact the issuer’s credit quality.
What Has Changed
The biggest change for municipal bond investors is the elimination of municipal bond issuers to utilize a popular financing technique known as advanced refunding. Municipalities traditionally used advanced refunding to refinance outstanding debt to save money on interest costs. For example, if borrowing costs have fallen from the time at which a municipality originally issued bonds, that municipality could issue new bonds at a lower interest rate and use the proceeds to repurchase the original, higher-cost bond issue. The elimination of advanced refunding could dramatically lower the supply of newly issued bonds in the years ahead, which would likely drive up the price and drive down the yield of municipal bonds.
The Law of Supply and Demand
The scaling back of the state and local tax (SALT) deduction that caps the deduction at $10,000 for property, state income or state/local sales taxes should create greater demand in high tax states such as New York, New Jersey and California. This increase in demand should drive up prices and drive down yields for municipal bonds issued by municipalities in these states. Despite personal marginal income tax rates declining, high-earners’ tax rates would still be high enough that yields for municipal bonds would be attractive relative to after-tax yields on taxable bonds.
As stated earlier, the elimination of advanced refunding should decrease supply of municipal bonds. Plus, many municipalities rushed deals to market ahead of the January 1, 2018 effective date of the new tax laws in anticipation of the elimination of the tax-exemption for advanced refunding bonds and possibly, private activity bonds. This combination of events has significantly depressed supply so far this year, and that trend should continue.
Like prices for most goods and services, the prices of municipal bonds are dictated by supply and demand. In aggregate, an increase in demand and decrease in supply should result in higher prices and lower yields. This could erode the tax benefits of municipal bonds for those investors not subject to high federal and/or state income taxes.
Credit Quality of State and Local Governments
The new tax law is likely to have a negative effect on state and local governments’ credit quality. The cap on total state and local tax deductions is detrimental for high-tax states, in particular areas with high property values. Capping the property tax and mortgage interest paid deductions could result in a decline in property values over time. This is problematic because most towns/cities rely on property revenues for a large portion of their revenues. Taxpayers in these states have already started to put pressure on their governments to reduce spending and voter rejection of property tax hikes could become more common in the future. The negative effect of tax reform on state credit pales in comparison to the larger macro trends of an aging population, growing budget deficits and chronic pension underfunding. These big picture issues will have a more meaningful impact on credit quality of state and local governments in the long run.
What to do Now
We do not believe investors should make broad, sweeping changes to their fixed income portfolios in reaction to the Tax Cuts and Jobs Act. In our view, even at moderately lower yields municipal bonds have an advantage over taxable bonds for those in the highest marginal tax brackets and/or those living in states with high tax rates. However, we believe it is important to focus on finding the optimal balance of risk and reward in the fixed income markets. That means targeting municipal bond issuers with higher credit quality and focusing on short and medium duration bonds. For investors with mid-level tax brackets, or for those that reside in a state with low or no income taxes, blending municipal bonds with taxable investment-grade bonds could provide an enhanced diversification benefit.
There are two components to any investment: risk and return. When we construct portfolios, the primary objective for the fixed income allocation is to reduce portfolio risk. While municipal bonds offer tax-sensitive investors the potential for greater after-tax returns, in the past that has come at the expense of higher risk. We continually monitor the fixed income markets and tax laws to determine if the risk of higher portfolio volatility is worth the reward of increased return.
If you have any questions about the effects of the new tax laws on the municipal bond market, or how the new tax laws affect your fixed income portfolio, please contact a member of the HIGHLAND team.