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Muni Bonds & Tax Reform: Where Things Stand Now

Timothy GroveAugust 24, 2018

Investments

Many of our clients are reliant on tax-free municipal bonds as an integral part of their portfolios and have expressed concern about the effect that the recently enacted tax reform (the Tax Cuts and Jobs Act of 2018) with its lowering of tax rates will have on the muni market.  There was much alarm in the financial world in late 2017 about a cataclysm in the muni market as a result of this tax reform.  However, at HFA, we continue to believe that muni bonds remain an essential long-term portfolio component for high bracket clients and the performance of the asset class so far this year bear this out.  According to Morningstar, the year-to-date return (as of 8/17/18) of the Bloomberg Barclays Muni Index is +0.18%, while the Bloomberg Barclays U.S. Aggregate (which is comprised of taxable bonds) has returned -1.10% for the same period.

Muni bonds are affected by changing interest rates just as taxable bonds are (when rates rise, prices fall) and we are certainly in a rising rate environment this year.  However, muni bond prices are affected by tax rates as well.  As I explained in this blog post, the income from municipal bonds is exempt from federal income tax, and may be exempt from state and local income taxes as well.  But this tax exemption comes with a price; yields on muni bonds are, as a rule, lower than the pre-tax yields on equivalent taxable bonds.  Therefore, muni bonds have an advantage over taxable bonds only at higher tax rates; the higher the tax rate, the more valuable muni bonds become when compared to equivalent taxable bonds.  Conversely, muni bonds are less advantageous at lower tax rates.  Under the tax reform, the top marginal rate for individuals and couples was reduced from 39.6% to 37.0%.  A more dramatic reduction to corporate rates went into effect-from 35% all the way down to 21%.  Corporations, especially banks and insurance companies, have traditionally been investors in muni bonds because of that 35% tax rate.  However, corporations comprise only about 25% of muni bond holders; the vast majority of muni bond investors are individuals.

At first blush, one would think that these rate reductions would seriously crimp the demand for muni bonds, thus driving their prices down.  True, but as is usually the case when dealing with the tax code, the reality is far more complex.  While rates for individuals and couples were reduced and the standard deduction was greatly increased, the deduction for state and local taxes (known as the “SALT Deduction”) has been capped at $10,000.  For high bracket clients who itemize, especially those living in high-tax states, their state and local taxes (which includes income and real estate taxes) can easily exceed this cap by a large margin.  This amounts to a countervailing tax increase, which makes muni bonds more attractive to those taxpayers and has actually helped support demand.

An analysis of the effects of the Tax Cuts and Jobs Act of 2018 on the demand side of the muni market should not be performed without equal attention paid to effects of the Act on the supply side.  Prior to the implementation of the Act, municipal bond issuers were able to perform what was known as an advanced refunding.  Muni bonds often have a “call provision”, which stipulates that, after a certain period, the issuer may “call” or pay off the bond issue prior to maturity.  Similar to a homeowner refinancing a mortgage, this would enable the issuer to take advantage of lower interest rates as a new bond issue would be made at a lower rate with the proceeds being used to pay off the older, higher yielding bond issue.  An advanced refunding was a way for a muni issuer to refinance a bond issue before it is able to be called (by definition, at least 90 days prior to the earliest possible call date)A new bond issue would be made at a lower rate, but rather than being used to immediately retire the original bonds as would be done in a “call”, the proceeds would be placed in a trust and invested in Treasury securities which would mature at the same time the call provision went into effect and these proceeds would be used to retire the original bond issue.  Under the new tax reform, this practice has been abolished and that has substantially reduced the supply of muni bonds in 2018, thus providing support to prices.  In late 2017, there was a large spike in the muni supply as issuers rushed to perform advanced refundings before they could no longer do so.  Furthermore, in late 2017 it was rumored that the Act would rescind the tax exemption on private activity muni bonds (used to fund the construction of quasi-public facilities such as sports venues).  This did not come to pass but there was a rush to issue private activity munis that would have been issued in 2018 in late 2017, further reducing supply this year.

In conclusion, we continue to believe in using municipal bonds for clients in higher tax brackets and we perform a thorough analysis of each client’s individual situation to determine whether taxable or tax-exempt bonds should be used.  We take a measured, long-term view and believe that the muni market will prove resilient and continue to adjust and adapt in response to any short-term dislocations caused by the Tax Cuts and Jobs Act of 2018, much as it did after muni bond insurers went the way of the dinosaurs following the 2008-2009 financial crisis.

If you have any questions or would like additional information, please call our office at 610-651-2777.  We would be happy to talk through your specific situation.

Sources

Investment News Article 7-23-18
Forbes Article 1-23-18
CNBC Article 2-23-18
Kiplinger Article 2-18
NYL Investments Blog 7-26-18
Baird Article 7-18
Seeking Alpha 7-28-18
Lord Abbett Article 3-5-18
Bloomberg Article 12-15-17