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Potential Impact of the Tax Cuts and Jobs Act on the Municipal Market 2018

Written by: Seix Tax-Exempt Strategies'
Ronald Schwartz, CFA, Managing Director and Senior Portfolio Manager, and
Dusty Self, Managing Director, Senior Portfolio Manager

Congress recently passed a sweeping tax reform bill that is expected to fundamentally alter the U.S. tax code. President Trump signed the bill into law, codifying the $1.5 trillion dollar package of reforms. In addition to altering the structure of both the corporate and personal tax codes, the bill is expected to have a far reaching impact on the municipal market. We believe this impact will be primarily focused on the areas of private activity bonds, advanced refundings, corporate demand for munis, and specialty state bonds.

Private activity bonds are bonds issued for 501(c)(3) entities such as hospitals, private colleges, airports, charter schools, and P3 (Public Private Partnership) projects. In earlier drafts of the tax bill, congress had proposed the elimination of these bonds due to concerns over wealthy private entities receiving tax-exempt financing benefits. Despite this, the final version of the bill left this area of the market unscathed, allowing unrestricted continued issuance. Going forward, investors must remain vigilant as private activity bonds may come under further scrutiny should talk of infrastructure spending return. Nonetheless, preserving this sector of the market is a positive for investors as these deals often present solid potential opportunities to pick up yield or find credits that are mispriced.

Advanced refundings are now prohibited in the municipal market, effective January 1, 2018. In the past, this mechanism allowed issuers to refinance their debt to take advantage of lower interest rates and save on debt service costs. Issuers will be permitted to issue taxable refunding bonds, but it is unclear if this will be feasible given higher rates for taxable debt. Over the last 10 years, refunding debt has made up 35%-55% of total issuance in the municipal market. In 2018, we expect that issuance will be down approximately 20%. New issue supply is likely to be around $335 billion and net supply is likely to be negative $125 billion. As a result, we could see the municipal market shrink by about 3%. If demand remains constant, this reduction in supply could be a net positive for the market, enabling munis to perform well relative to other asset classes. Another effect of the elimination of advanced refunding is a potential shift in the coupon structure for newly issued bonds. Up to this point, 5% coupon bonds have been the market standard, though some deals are issued with 4% or 6% coupons. With issuers no longer able to issue tax-exempt refunding bonds, we believe lower coupon bonds of 3% to 4% could become the market standard as issuers seek to reduce their interest expense. It is unclear how investors may react to this potential change, but we believe that 5% coupon bonds will become scarcer and
could consequently outperform.

The Tax Cuts and Jobs Act also lowers the corporate tax rate to 21% from 35%. Currently, banks and insurance companies hold approximately 29% of all municipal debt; however the tax bill could decrease their appetite to own munis given a decline in the value of the tax exemption. In practice, many companies have already been paying a tax rate far lower than the stated 35% and thus the decrease in demand may be more muted than some have suggested. Overall, we expect that this provision will decrease corporate demand for municipal bonds, though the overall impact on the market could remain moderate.

For individuals, the top personal tax rate is dropping from 39.6% to 37% and the state and local tax deduction (SALT) will be limited to $10,000 from property, income, or sales taxes. The reduction in the top tax rate should not have a material impact on the market given the rate reduction was small and we expect that investors in this bracket will continue to have strong demand for munis. The changes to the SALT deduction will have a large impact on residents of high tax states such as California, New Jersey, New York, and Connecticut, substantially increasing their effective federal tax rates. Because of this increase, we expect to see additional demand from high net worth investors in these states seeking to shield more of their income from federal taxes, which could lead to outperformance for bonds from these states. Overall, we believe that there will be a significant impact on the municipal market from the tax bill. A net decrease in supply, a decrease in corporate demand, lower coupon bonds, and strong performance by debt from high tax states should all be expected to materialize over the next year. Taken in concert, we believe that municipal bonds will remain a strong component of the investable portfolio for high-net-worth individuals and that this may be an attractive entry point given expected increase in volatility next year.

Image - Seix - Potential Impact of Tax Cuts 2018 - Muni Market Snapshot

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The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.


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