Certain provisions could impact supply and demand for US municipal bonds
Tax reform is currently underway in Congress and could have important implications for the tax-exempt municipal market. As we wait for a final agreement between the House and Senate versions — which could come as soon as today or tomorrow — we can make some observations about how tax reform is likely to impact the US municipal bond market, based on the details reported to date.
Municipal tax exemption preserved
The greatest perceived risk to the municipal market has been the potential elimination of its tax-exempt feature, but this was not included in either the House or Senate version of the tax law. Several other changes, however, could impact municipal credit quality and future supply and demand for municipal bonds. These are discussed below.
Possible termination of ‘Private Activity Bonds’ could impact municipal supply
Tax-exempt Private Activity Bonds (PABs) are used by governments to finance “private activity,” like the construction of airports. PABs are also issued by nonprofit organizations, such as not-for-profit health care systems and not-for-profit colleges and universities. The Internal Revenue Service establishes tests to determine if a bond qualifies as a PAB.1
The House version of the tax law included the termination of PABs,2 while the Senate version left PABs intact. It is difficult to predict the fate of PABs, but their elimination would require nonprofit organizations and government entities to issue taxable debt to finance activities currently paid for by issuing PABs. This should be favorable from an overall market standpoint since the supply of tax-exempt bonds would potentially decline, all else equal.
Possible elimination of advance refunding could impact municipal supply
Both the House and Senate versions of the law called for the repeal of advance refunding bonds, which are issued more than 90 days before a bond’s call date.3 While the repeal would limit an issuer’s ability to take advantage of lower interest rates, and thereby generate economic savings, the impact on bond credit quality would likely be limited, as issuers could still take advantage of lower interest rates through existing call provisions. The impact on the overall municipal market should be net positive, in our view, since advanced refunding has been significant over the past 10 years and this supply would be removed.4
Changes in individual and corporate income tax rates could impact municipal demand
The Senate version of the tax bill lowers tax rates on some individuals.5 Both the House and Senate versions include a reduction in the corporate tax rate — as of Dec. 14, the two chambers had reportedly agreed to cut the rate from 35% to 21%.6 Historical experience suggests that the impact of lower individual tax rates on municipal market yields is typically minimal.7 Reducing the corporate income tax rate from 35% to 21%, however, would likely reduce corporate demand for municipal bonds. US insurance companies (property and casualty, and life), banks and credit unions currently hold around 28% of total outstanding municipal debt.8
The impact of other potential changes
- Alternative Minimum Tax (AMT): The House is calling for the repeal of both the personal and corporate AMT, while the Senate bill would increase exemption levels for individuals, reducing the number of individuals subject to the AMT.9 As both of these actions would, in theory, lower tax burdens, this legislation would likely have a negative impact on the demand for municipal bonds.
- State and local taxes (SALT): Both the House and Senate plans cap SALT deductions at $10,000. We could see an uptick in demand for tax-exempt bonds issued by states with high tax burdens, such as California, New York and New Jersey, as investors seek to reduce them. However, capping the SALT deduction could be negative from a credit perspective, as states and local governments could face political challenges to increasing state tax rates. Additionally, residents in higher-tax states could see their disposable incomes decline, potentially reducing economic activity.
- Mortgage interest deduction: Capping the mortgage interest deduction at $500,000 (House version) could temper housing sales and the expansion of the tax base, especially in areas with higher-priced homes. This could have a longer-term negative impact on state and local government credit quality.
The importance of partnering with an active manager
The municipal bond market continues to grow in complexity, currently comprising over 36,000 government and non-government obligors.10 Important and historic changes to the US tax code would likely add another layer of complexity, making careful credit analysis an even more critical component of municipal bond investing.
1 Source: IRS Office of Tax Exempt Bonds, “Publication 4079 Tax-Exempt Governmental Bonds”
2 Source: Section 3601 of H.R. 1 (House version)
3 Source: Municipal Securities Rulemaking Board
4 Source: JP Morgan 2018 Municipal Market Outlook, Nov. 22, 2017
5 Source: Business Insider, Dec. 2, 2017
6 Source: Washington Post, Dec. 14, 2017
7 Source: JP Morgan US Fixed Income Markets Weekly, Oct. 28, 2016
8 Source: Board of Governors of the Federal Reserve System, “Financial Accounts of the United States” (2Q 2017)
9 Note: Corporate AMT under the Senate version would remain at the revised corporate tax rate, which was being reported as 21% as of Dec. 14, 2017.
10 Source: Bloomberg L.P., data as of Nov. 21, 2017
Mark Gilley, CFA®
Head of Municipal Research
Invesco Fixed Income
Mark Gilley is Head of Municipal Research for Invesco Fixed Income. His primary responsibilities include management and coordination of municipal investment research, credit analysis and credit strategy.
Mr. Gilley joined Invesco in 1996. Before joining the municipal team in 2011, he held analyst and portfolio management positions within Invesco Fixed Income. Prior to joining Invesco, he was with American Capital Asset Management. He entered the industry in 1992.
Mr. Gilley earned a BBA from The University of Texas at Austin and an MBA from The University of Missouri at Kansas City. He is a Chartered Financial Analyst® (CFA) charterholder.
Chief Investment Officer, Head of Municipal Strategies
Invesco Fixed Income
Mark Paris is Chief Investment Officer and Head of Municipal Strategies for Invesco Fixed Income. In this capacity, he is responsible for the oversight and implementation of all municipal bond strategies.
Mr. Paris entered the financial industry in 1990 and joined Invesco in 2010 when the firm combined with Van Kampen Investments. Prior to joining the firm, Mr. Paris was a trader and then a portfolio manager on the municipal fixed income team at Morgan Stanley/Van Kampen, which he joined in 2002. He also was previously a trader and portfolio manager at Oppenheimer Funds, head underwriter at Chase Manhattan Bank, and a trader and underwriter at NatWest Bank.
Mr. Paris earned a BBA degree in finance from Baruch College of the City University of New York.
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This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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