The tax-exempt municipal market has faced some challenges this fall: Yields trended higher in early October as the market struggled to digest the largest new issuance period of the year, and the indigestion has only increased following last week’s U.S. election outcome.
Municipal investors are now mulling what the shifting policy agenda under a Donald Trump presidency and Republican Congress could mean for their portfolios – and we see opportunities for active management amid the related volatility.
Heads or tails? The impact of tax policy
Changes to top marginal tax rates are nothing new, and historically they’ve offered little to fear for municipal investors. Since 1982, the top individual tax rate has changed eight times – and history has not shown a clear relationship between top tax rates and muni valuations (see chart).
Perhaps this is because municipals still offer value for U.S. tax-paying investors even well below the top marginal tax bracket. For example, at current valuations, muni investors in a 33% federal tax bracket (the top rate under Trump’s current tax proposal) would earn a higher after-tax yield than in similarly rated corporates: The Barclays AA Municipal Index yield of 2.15% offers a spread of 58 basis points (bps) over similarly rated duration-matched corporates on an after-tax basis (as of 14 November 2016).
Rising rates add to the tax exemption’s appeal
Following the election outcome, we continue to forecast two to three fed funds rate hikes before the end of 2017. And as absolute interest rates move higher and taxes eat up a greater absolute level of a U.S. investor’s taxable income, the value of the muni tax exemption increases. This helps explain why municipals have outperformed other fixed income asset classes in previous Fed hiking cycles – and this cycle is unlikely to be the exception.
Mixed impact from health care and infrastructure policy
It’s still early, and we have much to learn about President-elect Trump’s policy plans. But we do know that changes to the Affordable Care Act and a program to boost infrastructure spending are top priorities.