Implications of the Tax Cuts and Jobs Act for Municipal Bond Investors
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The 2017 Tax Cuts and Jobs Act will impact advisors and muni bond investors. Here’s what they should expect moving forward in 2018.
The Act’s most obvious change is a reduction in the highest marginal Federal tax rate from 39.6% to 37% for married filers earning more than $600,000, beginning this year. However, the Affordable Care Act’s 3.8% surtax on annual investment income over $200,000 remains as does the ACA’s 0.9% increase in Medicare taxes.
For those investors living in relatively high-income, property, and sales-tax states, limitations on the deduction of state and local taxes (SALT) will boost their adjusted gross income. This could cause an increase in federal taxes, all other things being equal. Along with the reduction of SALT, the standard deduction has been raised by nearly 90% to $24,000 for married couples, up from $12,700 in 2017.
In addition, the bill has particular significance for wealthy investors who will own homes with high leverage. They can expect their mortgage interest deductions to be limited on new loans of $750,000 or less, and only on a primary residence. This will hold true until at least 2026, when this and several other provisions in the new tax law are set to expire.
And wealthy investors will want to keep an eye on the expiration of the inheritance-tax exclusions. The new act ratchets up the 2011 Obama-era $5 million indexed individual exclusion to $11.2 million, with a sunset in 2026. Married couples can double the exclusion to $22.4 million. As more wealth passes to subsequent generations, we can expect more new municipal bond buyers.
Corporate tax rate cuts could reduce the value of buying tax-exempt municipals by large corporations and insurance companies. It is not clear yet how a possible reduction in demand from such investors might play out in 2018 or if corporate owners of municipals are going to be sellers. All other things being equal, we should see a reduction in demand, but given the race to issue new and refunded bonds in November and December, it may well be that supply falls as least as quickly as demand. It is also worth considering that corporate portfolio managers may be slow to move because of the uncertain future of the 2017 Tax Act’s sustainability, given the very political nature of its adoption.
For issuers, the year-end rush to market by state and local governments was motivated at least in part by the Tax Act’s elimination of tax-exempt advance refundings. Cost-saving refinancings have driven new issue volume for more than 30 years. In fact, before the 1986 Act was adopted, there were only minor limitations on the number of cost-saving advance refundings a state or local government might structure. Deliberations during the drafting of the 1986 Act concluded that the cost-saving proliferation of tax-exempt refundings was cannibalizing the taxable Treasury market’s demand, and therefore needed to be curbed. Consequently the 1986 Act limited advance refundings to a single cost-saving advance refunding during the life of the underlying project financed by tax-exempt bonds.
The 2017 Act inexplicably eliminated advance refundings as of the beginning of this year, unleashing the torrent of advance refunding issues at the end of 2017. We can be sure aggressive lobbying will be applied to reinstate cost-saving refinancings – in the meantime, we should expect reduced new issuance municipal volume in the first half of the year, at least.
In response to the loss of advance refundings, we can expect issuers to consider reducing call protection periods from a conventional 10 years and/or consider adding in premiums for the earlier calls. High-net worth investors tend to be less sensitive to early redemptions in comparison to some managed funds because of the funds’ need to provide practically daily liquidity in addition to performing well compared to benchmarks of comparable duration. It remains to be seen if and how reduced call protection will be penalized by the market.
Several market participants have observed that state and local government issuers may be driven to issue more variable rate debt, which has the benefit of being easily redeemed. At the same time, other market participants have suggested that floating-to-fixed-rate swaps may once again come into municipal market vogue as a way to lower costs. Finally, it has been suggested that forward purchase contracts may also be a solution for capturing interest rate savings. Under all of these “synthetic” alternatives there are costs and risks. Unfortunately, many state and local government issuers were damaged using such tools because of the 2008 financial collapse. Regulations since 2008 governing state and local government debt as well as letters of credit and swaps were imposed and will limit the reckless use of these financial tools absent ill-advised reforms.
Issuers are breathing easier knowing that private activity bonds for affordable housing and not-for-profit activities survived the rush to pass the new tax law. New market tax credits and historical tax credits also survived, but their value has been reduced as the credit is now earned over five years. Tax credits for affordable housing projects are now of lesser value (with corporate tax rates reduced), making it even more challenging to create an affordable housing project in high-cost communities. Finally and inexplicably, the new Act permits issuance of tax-exempt bonds for professional sports stadiums.
As we enter 2018 and the mid-term Congressional elections, we can expect a robust conversation about additional tax legislation and a national infrastructure plan, especially given the Joint Committee on Taxation’s estimate of the new Act’s $1.5 trillion dollar contribution to the national deficit over the next decade.
Tom Lockard is co-founder, managing director and head of investment banking at 280 CapMarkets, a firm bringing Silicon Valley to fixed-income capital markets.