Update: Monitoring Tax Reform’s Impact on Municipals

At the start of December, we shared our thoughts on tax reform and the potential implications for the municipal bond market. This immediately followed the Senate's narrow passage of its tax reform bill, an event that we viewed as a particularly important milestone, based on our expectation that the final tax reform bill would prove to be quite similar.

In the days and weeks since, a conference agreement on the tax bill was reached, followed by successful passage in both House (twice) and Senate. As the final bill moves on to the President's desk, where it may potentially be signed into law by Christmas, we revisit key points from our original piece and account for recent developments.

The topic of taxes and their effects on individuals and businesses have permeated American conversations for hundreds of years, helping to shape the nation’s identity well before its official inception – an event in which taxes, of course, played no small part. To this day, they remain top of mind for many, especially with substantive reforms on the horizon.

Tax reform legislation creates potential impacts across many asset classes, and the first that comes to mind for many is the municipal bond market. There are a number of benefits that municipal bonds provide, but their tax-exempt interest income continues to be their most well-known. Although non-traditional buyers have shown more interest in recent years, due largely to these benefits, the market is still heavily influenced by the domestic retail investor, who accounts for nearly 70% of the market. The make-up of the investment market is one of the key reasons why supply and demand are both so important, as demand from tax-sensitive investors and the supply of new bonds can often exert significant influences on market valuations and performance.

Tax reform itself is obviously quite complicated and nuanced, particularly as investors were monitoring both versions of the Tax Cuts and Jobs Act in recent weeks. In the days and weeks following the Senate's initial approval, a conference agreement was reached on the tax bill, which was subsequently approved by both the House and Senate. In terms of the impact to the municipal bond market, we believe it's important to consider implications in terms of supply and demand.

Investor Demand

The House and Senate versions had meaningful differences as it relates to the municipal market, but in both cases and as noted in our previous tax reform update, we believed demand for municipal bonds would remain high. While the House’s version would have been more bullish from a demand standpoint, both versions left top rates at levels that should continue to support robust demand for municipal bonds. The final version of the tax bill skews more towards the Senate’s version, reducing the top income tax bracket for individuals to 37%. While this represents a slight decline from the current tax rate, this is still a very high rate and we believe demand for municipal bonds will remain strong going forward. As anticipated, the final version doesn’t limit the amount of tax-exempt income an individual can receive, representing another positive with regard to investor demand.

As noted in our piece released in early December, the ability to deduct state and local income taxes, or SALT, primarily benefits high earners in states with high income tax rates. After initially calling for a full repeal of this deduction, the Senate’s bill was amended, bringing this element of the proposal in-line with the House bill, which limits SALT deductions to $10,000 per year for those who itemize. Although the deduction wouldn’t be fully eliminated, municipal bonds from such states could still benefit from increased demand as their tax-exempt characteristics would become incrementally more valuable. This would be the case in states such as California and New York, two areas of the market where we continue to find attractive investment opportunities.

Figure 1: States with the Highest Income Taxes (2016)

Sources: IRS, Barclays Research.

Potential Impacts for Supply

In the House bill, there were elements that would lead to a dramatic decline in the amount of supply based on proposals that do away with advanced refunding capabilities as well as private activity bonds (PABs). Advance refundings allow an issuer to obtain the benefit of lower interest rates when its outstanding bonds that offer higher interest rates have not reached their callable date. While meaningful, these bonds represent a smaller portion of the market compared to PABs, which include airports, toll roads, not-for-profit health care, and private universities. Ultimately, the final bill closely resembles the Senate version which eliminates advance refundings while keeping the tax treatment for PABs in place. While the reduction in supply is more modest as a result of PABs having no change, we still believe market technicals will be positive moving forward. At the same time, the market has experienced a significant increase in supply recently as issuers have been accelerating new deals as potential changes related to their municipal market access has been looming. We believe this supply increase is temporary and that municipal market technicals will be compelling in early 2018.

Municipal Market Impacts and Portfolio Positioning

While tax reform and the impact on the municipal market has been a popular topic of conversation for some time, its actual effects have become apparent more recently, with spreads widening over the last week as issuers have rushed to market in advance of potential changes. The primary driver of this activity is from issuers looking to advance refund their debt and lock-in a lower coupon, since the final bill does not allow for advance refundings next year. At the same time, new supply has been absorbed fairly well but the municipal market has faced some headwinds overall, particularly this week with year-end rapidly approaching.

Figure 2: Muni-Treasury Ratios Have Fluctuated Significantly as Tax Reform Efforts Have Progressed

Sources: MMD DataLine, Barclays Research, as of 12/19/2017.

Figure 3: Weekly Results Since the First Passage in the House Illustrate Short-Term Performance Headwinds

Source: Morningstar Direct, as of 12/19/2017.

Although this rush to market has caused spreads to widen, presenting some performance headwinds for the market, we believe the volatility has created attractive opportunities. As we navigate this short-term increase in supply, we believe the market is well-positioned for what could be a strong start to 2018, as positive technicals may follow these recent legislative developments.