With contributions from Gabe Diederich, CFA, Portfolio Manager
The municipal bond market continues to digest the most recent view into the tax-reform package—the Tax Cuts and Jobs Act of 2017, which offered additional details from prior proposals. It is important to note that this version of the tax-reform legislation is likely to change and therefore makes material repositioning of municipal portfolios challenging at this time. Our focus continues to be on understanding the implications of potential tax reform and adjusting our municipal investing strategy as the outcome becomes clearer.
Key implications for the muni market
- Reduced supply. Advance refundings, stadium financings, private activity bonds (PABs), and 501c3 nonprofits would no longer be allowed to issue tax-exempt debt. This newfound scarcity of tax-exempt supply would be supportive of existing municipal bond valuations. Hospitals and private universities, to name two major sectors that could be affected, are expected to lobby hard to maintain their access to the tax-exempt market. Levered, smaller issuers that could be excluded from the tax-exempt market would be hurt by the new rules and would need to find low-cost financing in the taxable market or direct bank lending market. Banning PABs for public private partnerships, a structure favored by the Trump administration, would increase their financing costs and be contrary to the Trump infrastructure goals. It is estimated that between 20% and 40% of new supply could be forced to issue debt in a taxable format if these combined changes were enacted. Stadiums would be retroactively banned from issuing tax-exempt debt as of the beginning of November 2017. However, if the full curbs for other sectors mentioned above are signed into law in the coming weeks, we would expect a boost of supply as issuers rush to beat the final sunset of tax-exempt market access, which appears to be year-end as currently proposed.
- Reduced demand. Corporations, namely banks and insurance companies, have been steady buyers of municipals in recent years and hold roughly one-third of the asset class. Because the corporate tax rate may be lowered from 35% to 20%, the effective tax rate for corporate debt would be lowered. Therefore, corporations will need to analyze where the best after-tax yield resides because income from taxable debt would be taxed at a lower rates. At current valuations, most intermediate- and long-term tax-exempt debt offers value compared to corporate debt, particularly in lower-rated credits. We continue to believe a reduction in marginal tax rates may diminish demand from corporations, but is unlikely to lead to a mass exodus from municipals. This is because book yields will remain attractive, if market yields remain within a 50 basis point (bp; 100 bps equal 1.00%) range from today’s yield levels, which we think is a reasonable assumption for the near term. We expect the asset class will remain valued for its diversification properties and high ratings profile.
- Increased demand. If state and local tax deductions disappear, individual investors in states with high tax rates would have an even greater incentive to buy in-state munis.
- Alternative minimum tax (AMT) repeal. AMT yield spreads over similar, non-AMT municipal bonds remain positive, reflecting doubt about the passage of this tax change. If the elimination of AMT passes, it is possible that AMT bonds may outperform comparable municipals not subject to the AMT.
- Treasury yield shifts. Treasury bond market valuations currently do not suggest that investors expect the current version of the tax plan to pass. If the current version is passed, it would upset the prevailing bond-market positioning that expects Washington, D.C. gridlock reigning supreme. The risk is that if this version of tax reform passes and Congress doesn’t find the money to pay for tax reforms, deficit expansion by definition would boost the supply of Treasury debt and may cause yields to move higher.
After the initial tax reform proposal was announced, longer-term municipal prices rose because expectations for less supply drove the market more than other considerations. This flattening of the yield curve could reverse if other key implications gain more ground in investor outlooks.
The Senate and House of Representatives are each debating amended versions of this initial tax reform proposal. In our view the broader economic trends and fundamentals of municipal issuers remain the primary drivers of long term valuations. Still, investors must be prepared to understand impacts on the market and make investment decisions based on relative valuations as new information emerges.
What are the potential muni market implications of tax reform legislation?
|Tax reform measure||Potential muni market implication|
|Certain types of tax-exempt debt no longer allowed||Less supply|
|Elimination of AMT||Outperformance of municipals subject to AMT|
|Treasury bond market reaction||Discounting tax reform and yields could move higher if it becomes law|
|Municipal yield curve||Flattened in response to tax-reform proposal but may be overdone|
Any tax or legal information in this post is merely a summary of our understanding and interpretations of some of the current income tax regulations and is not exhaustive. Investors should consult their tax advisor or legal counsel for advice and information concerning their particular situation. Wells Fargo Funds Management, LLC; Wells Fargo Funds Distributor, LLC; or any of their representatives may not give legal or tax advice.