Market expectations about potential policy changes following the recent elections have led to a rise in yields in the muni market.
The potential for lower tax rates and increased state and local government bond issuance, along with rising Treasury yields, have hurt municipal bond prices recently.
However, some of the reaction reflects the market’s digestion of election news. And we think the benefits of tax-exempt income and the generally strong credit quality of the muni market are still positives.
The investment landscape for municipal bonds appears to be changing. The recent presidential election has increased the likelihood of tax cuts and an increase in tax-exempt municipal bond issuance—which could both be negatives for the muni market. Such concerns appear to have led to a selloff in munis in the weeks leading up to and just after the presidential election.
Have these changes undermined the case for munis? We don't think so, but we think the near term risks are higher than they were prior to the election. While the market could face challenges, they are balanced by some positives. And talk of tax cuts, on its own, isn't a reason to significantly change investment strategy. We think high-quality munis are still an attractive option for investors looking for tax-advantaged investments.
So what has changed and what impact might it have on municipal bonds?
Lower taxes could be a negative for municipal bonds
One of munis' most attractive features is that they pay income that is generally exempt from federal and possibly state income taxes. And because the top tax rate on investment income is now the highest it has been since 1981, demand for munis has been strong. That has boosted prices.
That could change now that the election results appear to have made tax cuts more likely. Congressional Republicans and President-Elect Donald Trump have proposed changes that would lower income taxes as well as taxes targeting investment income. In the near term, lower taxes, all else being equal, could reduce demand for municipal bonds.
The top tax rate on investment income is the highest it has been since the ’80s
Source: Tax Policy Center, as of 9/18/2015.
Note: The ACA tax is a 3.8% surcharge on "net investment income."
We looked at munis' historical performance to see how the potential for tax cuts can affect their performance. We found that in the year before the top tax rate decreased from the prior year, munis underperformed Treasuries by an average of 5.2%.
Munis have underperformed Treasuries on average when tax rates were lowered
Source: Schwab Center for Financial Research using data from Barclays and the IRS, as of 11/15/2016.
Note: Historical averages are calculated by observing the difference in the annual total return of the Barclays Municipal Bond Index ("municipals") and the Barclays U.S. Treasury Index ("Treasuries") from 1980 to 2015 in the year before the top marginal tax rate increased, decreased or stayed the same. Past performance is no guarantee of future results
Longer-term, municipal bond performance has shown little connection with changing tax rates. Marginal income tax rates for higher-income earners have generally fallen since 1980, with the exception of the recent hike and reversal of the tax cuts signed by President George W. Bush. Municipal bonds suffered annual losses in only eight of those 36 years.1
At the same time, lower tax rates could spur economic growth, which could push down bond prices and raise yields for bonds generally, as stronger growth can boost inflation, leading to higher interest rates in turn.
Increased infrastructure spending could also hurt munis
Since 2009, the supply of Treasuries in the market has grown by nearly 85%, while corporate debt has expanded 42%. In contrast, the supply of munis has increased just 0.1%.2 This happened even as demand for munis strengthened in the face of rising tax rates. The combination of tight supply and growing demand buoyed prices, which supported total returns.
Those conditions could change soon. One of the issues that both Democrats and Republicans have championed this election cycle has been an increase in infrastructure spending, which could result in an increase in the issuance of municipal bonds.
Of course, state and local governments are the bodies that issue municipal bonds, not the federal government, and it's possible any increase in spending will occur at the federal level or in taxable public-private partnerships that don’t result in a significant increase in tax-exempt bond issuance. But it's worth noting that in the recent election, voters approved $60.2 billion of the $70 billion in bonds appearing on ballots nationwide, according to capital-markets data company Ipreo, so it appears the public is in a mood to spend.
If issuance picks up as part of a broader surge in infrastructure spending, munis could face headwinds.
We don’t believe investors should avoid municipal bonds
Despite all these potential changes, muni investors shouldn't overreact. While it may take some time for the market to absorb the new tax-cut expectations, investors may already have started factoring in some of the potential headwinds, as evidenced by the recent rise in muni yields.
All things considered, we also believe the positives for munis help balance out the potential near-term risks. First of all, muni valuations are still near their long-term averages, despite the recent volatility. For example, the yield on a 10-year AAA-rated municipal bond is approximately 97% of that on a 10-year U.S. Treasury—not far from the historical average of 99.6%. After factoring in the tax benefits that municipal bonds offer, yields on top-rated munis are often higher than those on Treasuries.
Valuations for munis are near their long-term averages
Source: Bloomberg, as of 11/15/16.
At the same time, credit conditions for most municipalities have either been stable or improving, in our opinion. For example, state revenues have increased for 24 of the past 25 quarters,3 and state and local employment has increased for 34 straight months.4
Finally, the drop in muni prices since the election may have given long-term investors more opportunities to find higher yields. Fund managers could find similar opportunities.
At what tax rate do municipals continue to make sense?
Munis' attractiveness relative to other fixed income assets depends in part on where tax rates end up. Using today’s yields on 10-year bonds as a starting point, we found that at federal rates above 15%, municipal bond yields were greater than the after-tax yields for both Treasury and corporate bonds of similar credit quality.
By way of comparison, Trump's tax plan calls for reducing today’s six income brackets to three: 12%, 25% and 33%. The plan would also repeal the Alternative Minimum Tax. For investors, Trump’s plan calls for a 20% tax rate for capital gains and dividends. He would repeal the Net Investment Income Tax, the 3.8% surtax on investment income for wealthier filers that was imposed as part of the Affordable Care Act.
At federal tax rates above 15%, municipal bonds yield more after taxes
Source: Bloomberg, as of 11/15/16.
Note: The "after-tax" yield for corporate and Treasury bonds is found by calculating the yield on corporate or Treasury bonds times (1 – the tax rates). Corporate bonds assume an additional 5% state tax rate.
There’s a long way to go before actual policy implementation
Remember, any changes to tax law or infrastructure spending would require consensus in Washington, and we think that could take time to develop. We also believe that the policies that were proposed on the campaign trail could take a different form if and when they are actually implemented.
What to do now
The muni market may face some near-term obstacles. Yields have risen and prices have dropped since the election, as the market has begun to absorb expectations of the potential changes mentioned above. Some of the recent market volatility is also a response to rising Treasury rates. However, even though the potential for tax cuts and/or increased infrastructure spending has increased as a result of the election, we still think municipal bonds make sense as a core holding in taxable accounts of high-income investors.
For assistance in reviewing your bond portfolio, please consult your local Schwab specialist or a Schwab Fixed Income Specialist.
1As represented by the annual total return on the Barclays Municipal Bond Index, data from 12/31/1980 to 12/31/2015.
2Source: Securities Industry and Financial Markets Association (SIFMA), as of 9/16/16.
3Source: The Nelson A. Rockefeller Institute of Government, as of Q1 2016.
4Source: The Bureau of Labor Statistics, as of 11/4/16.
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