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Federal Tax Reform and the Municipal Bond Market

The House passed its tax reform bill and the Senate is slated to vote on its version as early as this week. Importantly, both versions preserve the tax exemption of municipal bonds. There are common features as well as differences in the two proposals, and the differences must be resolved before the bill becomes law.

(Estimated reading time: 2 min 24 sec)

What are the potential positive and negative impacts on the municipal bond market?

Both the House and Senate bills disallow advance refunding bonds (roughly 22% of issuance year-to-date). While the longer term effect on prices is positive as supply is diminished, increased issuance before the legislation takes effect could cause short-term weakness. Advance refunding bonds (also known as pre-refunded bonds) are roughly 8% of the muni bond market.

+ Both proposals maintain a relatively high top tax bracket for individuals (Senate: 38.5%; House: 39.6%) thus preserving the appeal of municipal bonds and sustaining demand. Tax brackets differ under the two plans, so the ultimate impact on broad-based demand is not yet known.

+ Both versions eliminate or cap deductions for state and local taxes (SALT). To lessen the state and local tax burden, demand will likely remain robust for residents in high-tax states such as New York, New Jersey, and California.

+ Both versions repeal the alternative minimum tax (AMT), which has already resulted in price appreciation of AMT bonds. AMT bonds comprise a relatively small part of the market (~3%).

+ The House version eliminates private activity bonds (PABs), which help to finance many of the nation’s non-profit hospitals, non-profit universities, airports, low-income housing developments, and critical care facilities. If this feature becomes law, issuance would be reduced and these projects would need to be funded in the taxable market, thus raising borrowing costs for these entities. This is a material and contentious change and this segment comprises about 15% of the market.

Both versions lower the corporate tax rate from 35% to 20% (the Senate delays this until 2019 while the House effect would be immediate). This would reduce the incentive for taxable entities (corporations, banks, and insurance companies) to hold municipal bonds. Federal Reserve data indicates that these entities held 23% of outstanding municipal bond debt as of June 30, 2017, so this could have a meaningful impact on both future demand as well as potential selling pressure on the market if they opt to sell their holdings.

In summary, while the final bill is yet to be seen, most provisions are likely to lend support to the tax-exempt municipal market over the longer term. Volatility is expected over the near term as details are finalized and digested by the market. Further, there could be short-term pressure on the market given an expected spike in supply going into year-end as issuers come to the market in advance of expected legislative changes.