For observers of the municipal bond market, the key issue going into 2018 is the fate of the tax reform legislation. As of the writing of this column, proposals included in both the House and Senate versions of the bill have the potential to curb issuance of tax-exempt munis and perhaps even negatively impact the credit quality of some issuers in certain sectors of the muni market. The House and Senate are reported to have reached an agreement in principle on how to reconcile their bills, but the final bill hasn’t been released and details are scant.
Though it's not yet certain a final bill, much less any individual provision now included in the existing drafts, will become law, we still suggest muni investors focus on higher-quality bonds with an average credit rating of AA/Aa2 and an average duration in the five-to-eight-year range. In our view, such bonds offer the most attractive balance of risk and reward.
Tax legislation has the potential to impact tax-exempt issuance and negatively affect certain sectors
Overall, we don’t think the tax legislation will hurt the attractiveness of munis among individual investors. Both bills lower taxes for most individuals. However, based on analysis we’ve done and read elsewhere, high-earners’ tax rates would still be high enough that yields for munis would still be attractive relative to after-tax yields on taxable alternatives.
Both the Senate and the House have passed versions of the tax bill, and lawmakers say they have an agreement on how to reconcile them, but the resulting legislation will still need to be submitted to another vote—apparently slated for early in the week of Dec. 18. We think the likelihood of both chambers of Congress passing a final bill is rising, but it’s still not certain. Final passage could happen at the end of that week.
The good news for muni investors is that neither bill seeks to repeal the municipal bond tax exemption. Nor do they seek to repeal the 3.8% tax on net investment income for high-income earners. The 3.8% tax doesn’t apply to munis, but it does apply to all other forms of investment income, making muni bond interest more attractive relative to taxable alternatives.
An issue to watch for muni investors is that the two bills could curtail the issuance of tax exempt munis and negatively impact the credit quality of some issuers in certain sectors.
Tax-exempt issuance could dwindle if the legislation becomes law
The House bill would eliminate the ability to issue private activity bonds (PAB) after Dec. 31, 2017, while the Senate bill would leave that ability intact. Reports are that the reconciled bill will keep the ability to issue tax exempt PABs, but may tighten rules on their use. Final details about how the reconciled bill will treat PABs hadn’t been released as of the time of this writing. PABs are tax-exempt bonds issued on behalf of a state or local government to provide financing for qualified projects. They are often issued by enterprises such as hospitals, nonprofit colleges and universities, and airports. Getting rid of this kind of bond would be significant for the muni market: PAB issuance accounted for roughly 20% of new issues in 2016, according to the Bond Buyer.
If the ability to issue tax exempt PABs is eliminated in the final bill, issuers who previously issued tax-exempt bonds may have to issue taxable bonds. Taxable bonds usually carry higher interest rates because their interest is usually subject to federal and state income taxes, unlike most munis. This could result in higher interest costs for issuers, which could therefore negatively hurt their credit quality.
The two bills also eliminate the ability of muni issuers to utilize advanced refundings, a tool that muni issuers use to refinance their outstanding debt, generally to save on interest costs.
Issuers appear to be already responding to the legislation even though it hasn’t yet become law. To take any ambiguity off the table about potentially losing the ability to issue tax-exempt private activity bonds and utilize advanced refundings, bankers and issuers have rushed to get deals done prior to end of the year. The amount of new issuance coming to the market over the next 30 days spiked at the end of November to its highest level in 12 years and remains high. As a result, interest rates for municipal bonds have been much more volatile than those for Treasuries.
Be selective when choosing local general obligation bonds (GOs), hospital bonds and healthcare bonds
A potential reform bill could impact certain sectors of the muni market in other ways. We don’t suggest broad sweeping changes to your investment strategy, but we do think investors should be aware of the following issues facing certain parts of the market:
- Local GOs in areas with high property values. The agreement reportedly allows taxpayers to deduct up to $10,000 in property, state income or state/local sales taxes. Taxpayers would be allowed to use a combination of property and income taxes or property and sales taxes. Current law allows for filers to deduct both state and local taxes paid and property taxes. The reconciled bill will also reportedly eliminate the ability to deduct mortgage interest paid for new mortgages above $750,000. For individuals in areas with high property values, such as New York City or the San Francisco Bay Area, eliminating or capping these deductions could result in a decline in property values over time.
Most cities rely on property revenues for a large portion of their revenues. According to Standard & Poor’s, if the state and local tax deduction is eliminated and the mortgage interest deduction lowered, it could negatively affect the credit ratings of issuers in more affluent areas–which tend to have high credit ratings.
- Higher education bonds issued by lower rated issuers. The tax bills could directly impact higher education issuers. Higher education issuers commonly issue tax-exempt PABs. If this ability is eliminated or curtailed, such issuers may have to issue taxable debt at higher interest rates. Bonds that are taxable usually carry higher interest rates because they don’t offer the tax benefits that munis do.
Changes in individual taxes may also negatively impact the affordability of colleges. According to S&P, “the removal of student loan interest deductions in the House bill would make college less affordable, affecting overall matriculation and retention rates.” If you’re investing in bonds issued by higher education issuers, we suggest sticking with higher rated bonds.
- Lower rated not-for-profit health care issuers. As with higher education issuers, the inability to issue tax-exempt PABs could result in higher borrowing costs for not-for-profit health care issuers. According to Municipal Market Advisors, smaller issuers could also lose market access altogether and therefore be forced to turn to more expensive borrowing options. This could lead to an increase in defaults for smaller local area issuers like rural hospitals, in MMA’s view. If you’re investing in not-for-profit health care issuers, we suggest sticking with higher rated issuers because the credit impact of higher borrowing costs is likely to be felt more by already lower rated issuers, who operate on tighter budgets to begin with.
Again, we don’t suggest wholesale changes to your investment strategy because the final details of the bill haven’t been released yet, they could change and the bill isn’t law yet, but these are some issues to be aware of.
For more information on the proposed tax plan, see “Tax Reform: Frequently Asked Questions,” as well as ongoing commentary on events in Washington written by Michael Townsend, director of legislative and regulatory affairs for Schwab.
We suggest an average duration between five and eight years
An average duration between five and eight years offers an attractive balance of risk and reward today because of valuations relative to Treasuries, the steepness of the municipal yield curve, and our view that interest rates for the broad muni market will modestly increase next year.
The municipals-over-bonds (MOB) spread is one of the metrics we use to analyze the attractiveness of municipal bonds. The MOB spread is the ratio of the yield on a AAA-rated municipal bond relative to a Treasury bond of equal maturity before accounting for taxes. The lower the ratio, all else being equal, the less attractive munis are relative to Treasuries before taxes.
Today, relative valuations for short-term munis are well below their longer-term averages. Relative valuations for longer-term munis are as well, but not as far below the average for munis with shorter maturities.
Relative valuations for munis are below their longer-term averages
Source: Bloomberg, as of 12/8/17
*Note: 1-year maturity is not to scale
Valuations relative to Treasuries matter because, based on our analysis, at lower valuations, munis are less likely to outperform Treasuries. For example, as shown in the chart below, we found that when the 10-year MOB spread was below 85%, municipal bonds underperformed Treasuries by an average of 1.7% over the next six months and 3.1% over the next 12.1 Munis, on average, performed better relative to Treasuries at more attractive valuations.
Munis have underperformed Treasuries on average at lower relative valuations
Source: Bloomberg using monthly data from 1/31/11 to 11/30/17. Municipal bonds are represented by the Bloomberg Barclays Municipal Bond Index and Treasury bonds are represented by the Bloomberg Barclays Treasury Bond Index.
We also currently favor an average duration between five and eight years, for most investors, due to the steepness of the yield curve. The difference between the yield on a 10-year AAA-rated muni and a two-year AAA-rated muni is only 80 basis points—which is near the lowest it’s been since the beginning of 2008. The flatter the yield curve, the less incremental benefit there is from investing in bonds with longer maturity, because of the smaller increase in yield for every additional year to maturity. Longer-maturity bonds also involve higher interest rate risk — that is, the risk that the value of the bond will rise, or fall, if interest rates change—than shorter-maturity bonds.
We think that interest rates on municipal bonds will modestly increase in 2018, driven by modestly higher rates for Treasury bonds. Despite the potential for rates to increase, we don’t think investors should avoid municipal bonds in 2018. Rising interest rates are generally a negative for short-term fixed income returns because interest rates and prices move in opposite directions. Longer-term bonds are more sensitive to rising interest rates than shorter-term ones. We think returns can still be positive, but that will likely reflect returns from coupon payments rather than price appreciation. Although rising rates are generally negative for short-term returns, they can be beneficial over the longer-term for a well-diversified bond portfolio because you can reinvest maturing bond proceeds and coupons at higher interest rates.
Investors concerned about rising interest rates should target the shorter end of our suggested range of between five and eight years. If you need the money in less than five years, consider investing in shorter maturities. Due to high relative valuations for short-term bonds, investors with short-term needs may also want to consider other highly rated taxable alternatives, like Treasuries or certificates of deposit because they may yield more than munis after accounting for taxes.
What to do now
The tax legislation is still a work in progress and rapidly evolving. We don’t suggest investors should make sweeping changes to their muni portfolios based on the current state of the bills in Congress. However, since potential future changes to the tax code could negatively affect some issuers, we suggest investors target an average credit rating of AA/Aa2 for their municipal portfolio. If investing in mutual funds, the benchmark duration for many intermediate term bond funds is approximately 5.7 years, so a benchmark duration makes sense in our view.2
If you’re looking for professional help, work with a Schwab representative to help find the right investments for you. Schwab also offers a breadth of professional portfolio solutions for all or part of your municipal bond portfolio.
1Using monthly data for the Bloomberg Barclays US Treasury Index and Bloomberg Barclays Municipal Bond Index from 12/31/86 to 11/30/17.
2As represented by the Bloomberg Barclays Municipal Bond Index, as of 12/08/17.
What you can do next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
- Explore Schwab’s views on additional fixed income topics in Bond Insights.