When Washington takes on tax reform, how will that affect munis?

February 8, 2017

 

With a new administration in office, we are already seeing some of the effects these political and economic changes in Washington are having on the bond markets.

Just days after the November election, bond prices tumbled as bond yields increased dramatically. The yield on the benchmark 10-year U.S. Treasury rose nearly 50 basis points, jumping from 1.83% to 2.30%. And in an extremely unusual occurrence, pre-tax municipal bond yields have actually been higher above Treasury yields. The 10-year portion of the AAA-rated municipal bond curve rose from 1.72% to 2.45% over the month of November, retreating somewhat to 2.35% by the end of December, with both representing a higher increase relative to the movement in the Treasury yield curve.

While the increase in yields put downward pressure on municipal bond prices over the short term, total returns for the asset class bounced back in December. This volatility may linger throughout 2017, since uncertainty may rule the landscape.

Muni AAA benchmark yield curve

Benchmark yield curve

Bloomberg Barclays municipal indexesNovember 2016
Total return
December 2016
Total return
Municipal Bond Index–3.73%1.17%
3 Year Municipal–1.28%0.28%
5 Year Municipal–2.68%0.50%
10 Year Municipal–4.48%1.44%
20 Year Municipal–4.21%1.71%

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

In fact, any discussions regarding the impact the new administration and the Republican-controlled Congress will have on the bond market—in particular, the municipal bond market—seem to generate more questions than answers.

What's driving this unusual behavior in the municipal bond market?

Markets experienced their first meaningful increase in rates in quite a while immediately after the election. This large increase was mostly a by-product of the market pricing in more optimistic expectations for economic growth from expected expansions in fiscal policy. Another contributing factor was the heavy presence of year-end tax-loss selling.  With municipals trading more cheaply, buyers started coming back into the market in late November and early December.

How will proposed tax reform affect the role of municipal bonds?

Tax reform is widely touted as a priority for the new administration. A proposed overhaul of the tax code would decrease tax liabilities for both individuals and corporations. Additionally, bond issuance could increase to help support the infrastructure spending the Trump Administration has proposed. However, how all this will affect municipal bonds is still uncertain.

The U.S. House of Representatives has proposed reducing marginal tax rates for most individuals and corporations. On an individual basis, we don't believe the plan to reduce the number of tax brackets from six to three will meaningfully affect municipal bond investors. Unless tax rates drop to unexpected levels, municipal bonds should remain an attractive option on a risk-adjusted return basis, even for those in a proposed 33% highest bracket.

On the corporate side, lowering the corporate income tax rate from 35% to 15% is being proposed. This can potentially affect demand because muni bonds would become less attractive relative to corporate bonds, especially for such institutional buyers as banks and insurance companies. At a 15% level, this may potentially lead to mild upward pressure on yields, resulting from decreased demand.

Calling for a cap on the level of tax deductions has been discussed, which would bring the municipal exemption into play. One proposal caps deductions above a specific level. Another proposal places a 28% cap on the exemption, which would effectively impose a 5% tax on otherwise tax-exempt interest for investors in the proposed 33% top tax bracket.

Reducing the value of the exemption is a possible scenario that could lead to higher municipal yields and lower values for bond owners. Chris Alwine, head of Vanguard Municipal Group, said: "If these reforms are implemented, the value of the tax exemption would be reduced. Markets would react by demanding higher yields to own municipal bonds, which is expected to return the value of the tax exemption to levels close to where they were before. Recently, however, signs seem to point toward the tax exemption likely surviving in its current form. We plan to keep a close eye on this and other tax proposals as the year unfolds."

Will increased infrastructure spending affect the muni market?

Another priority of the new administration is to increase spending on infrastructure, leading to an increase in fiscal spending. And municipal bonds are the primary source of funding for such projects. Ed Saracino, senior product manager for Vanguard Municipal Bond Funds, said: "Rebuilding the nation's infrastructure appears to be a priority of the new administration. However, specific areas of focus and details on financing have not emerged at this time. We anticipate getting more clarity as the debate evolves."

What does this mean for your clients' bond portfolios?

As always, your clients should be reminded of the value of sticking with their long-term plans and not being influenced by either short-term returns or the daily headlines. Municipal bond funds offer relative stability and income potential, something your clients may be seeking in this period of political and economic uncertainty. We believe that municipal bond funds remain an important component of a diversified portfolio, especially for those clients seeking a low-cost, steady stream of tax-free income.

Notes:

  • All investments are subject to risk, including the possible loss of principal.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
  • Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
  • Past performance is no guarantee of future returns.
 

Our insights straight
to your inbox

Our insights straight to your inbox

Receive our latest Advisor's Digest
research
and commentary sent the
first business
morning every week.

A weekly digest of our latest research and commentary. Topics include the economy and markets, portfolio strategy, ETFs, and practice management.


Fund openings/closings, fund manager changes, dividend distributions, webinars, and other events you might want to know about.



Already registered? Log on to
manage your
email subscriptions.