Two Ways Tax Reform Is Impacting Muni Bonds

New York - The Tax Cuts and Jobs Act of 2017 included a number of changes that have directly impacted the $3.7 trillion municipal bond market.

Two changes in particular -- the capping of state and local tax (SALT) deductions and the elimination of tax-exempt advanced refunding’s -- are making it more challenging for investors and financial advisors who are "going it alone" when managing portfolios of muni bonds.

Higher demand and lower issuance

Why exactly is it getting more difficult for individuals to oversee muni portfolios after tax reform?

First, by capping SALT deductions at $10,000, the changes raise an investor's effective state income tax rate. However, income from an in-state muni bond remains exempt from this (higher) state income tax. Therefore, we expect demand for in-state bonds will increase -- especially in states with high income tax rates.

Higher demand is likely to result in lower yields relative to those available from out-of-state bonds. Investors and advisors who build their own muni portfolios in high-tax states may already find this task challenging because of reduced dealer inventories and limited access to new issues. The recent tax changes are likely to make it even more difficult to implement a state-specific muni mandate.

Additionally, the elimination of tax-exempt advanced refunding’s should result in less issuance. New issue volume is down over 40% so far in 2018 when compared to the average volume of the last five years.

For example, California has the highest top marginal state income tax rate in the country at 10.85%. At the same time, California new-issue volume is down 45% year to date. This has brought California muni spreads to all-time lows.