Tax rates could fall, but we don’t think that should be a big worry for municipal bond investors.
However, potential changes in supply and demand for muni bonds could make the market more volatile.
We suggest investors wait until a final tax bill becomes law before considering changes to their portfolios.
How might tax reform affect the municipal bond market?
Amid all the discussion surrounding the competing tax bills issued by the House and the Senate, this might seem like a peripheral issue. However, changes to the tax code could cause municipal bond issuers to scale back issuance, which could lead to greater price volatility, and impact a key benefit of munis: They pay interest income that is usually exempt from federal income taxes, as well as state and local income taxes, if the bond is issued in your home state. All else being equal, lower tax rates could hurt the attractiveness of munis relative to taxable alternatives.
Both the House and Senate tax proposals both aim to lower rates, but the bills differ in other ways that could also affect the market, as we'll see below.
But before digging into the details, it's worth noting a few things:
- The tax cuts in both the current proposals are not large enough to totally undermine the case for munis, in our view.
- We're still very early in the process. The House and the Senate bills would need to be reconciled before they could become law, and the road ahead could be difficult.
- Muni investors shouldn't start thinking about changing their muni allocations until we have a final bill that is law.
What’s in the proposals?
The good news for the muni market is that both the House and Senate proposals keep the municipal bond tax exemption intact. There was some talk before the proposals were released about whether the exemption might be scrapped.
Also notable is that the proposals do not repeal the 3.8% tax on net investment income for high-income earners. While the 3.8% tax doesn’t apply to muni bond interest, it does help make muni bond interest more attractive relative to taxable alternatives.
Here are some other points where the bills overlap and where they differ:
Same or Different?
|Maintains tax exemption of municipal bonds||Maintains tax exemption of municipal bonds||Same|
|Four tax brackets with the top being 39.6%||Seven tax brackets with the top being 38.5%||Different|
|Nearly doubles standard deduction||Nearly doubles standard deduction||Same|
|Eliminates personal and dependent exemptions||Eliminates personal and dependent exemptions||Same|
|Caps deduction at $10,000 for property taxes||Eliminates deduction for state and local taxes entirely||Different|
|Repeals Alternative Minimum Tax (AMT)||Repeals AMT||Same|
|Leaves taxes on investment income unchanged||Leaves taxes on investment income unchanged||Same|
|Cuts corporate tax rate to 20% with immediate effect||Cuts corporate tax rate to 20% beginning in 2019||Different|
|Eliminates issuance of tax-exempt bonds by private activity issuers (PABs)||Preserves issuance of tax-exempt bonds by private activity issuers (PABs)||Different|
|Eliminates advanced refundings||Eliminates advanced refundings||
|Eliminates use of tax-free bonds to build stadiums||Eliminates use of tax-free bonds to build stadiums||Same|
Sources: U.S. House of Representatives and U.S. Senate, as of 11/9/17.
Demand from individual investors is unlikely to be affected
Overall, we don’t think such changes would hurt demand for munis among individual investors.
Under the House’s plan, taxpayers with incomes above about $148,800 would see their tax bills drop by approximately $4,800, according to the Tax Policy Center. For taxpayers with much larger incomes, the benefits are even greater, in both an absolute sense and as a percentage of income, according to the Tax Policy Center. All things considered, 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, in our view. The Tax Policy Center hasn’t released its analysis of the Senate bill yet, but we would expect munis to retain their appeal if tax rates are lowered as outlined in that proposal.
The chart below shows the federal income tax rate at which the after-tax yield on a 10-year AA-rated corporate bond would be identical to the yield on a 10-year AA-rated muni bond. It’s 25.6%. At tax rates above that level, a AA-rated 10-year muni would yield more than a 10-year AA-rated corporate bond after taxes.
Although the current plans reduce the amount of taxes high-income earners would pay, according to the Tax Policy Center’s analysis, they wouldn’t hurt the attractiveness of munis relative to taxable alternatives, in our view.
Munis yield more than corporate bonds after taxes at tax rates above 25.6%
Source: Bloomberg, weekly data as of 11/9/17. Calculation based on the U.S. General Obligation AA Muni BVAL Yield Curve 10 Year Index (BMSC2A10 Index) and the USD U.S. Corporate AA+ AA AA- BVAL Yield Curve 10 Year Index (IGUUDC10 Index). The after-tax yield for corporate and Treasury bonds is found by calculating the yield on corporate or Treasury bonds times (1 – the applicable tax rates). Corporate bonds assume an additional 5% state tax rate.
Eliminating the state and local tax deduction could increase demand for munis in high tax states
The House version of the bill would cap property tax deductions at $10,000, while the Senate’s proposal would fully repeal the ability to deduct state and local income taxes. The ability to deduct state or local taxes from federal income taxes is especially beneficial for individuals in high tax states like California and New York. Getting rid of that provision would be equivalent to increasing the marginal tax rate for taxpayers in such states.
Should the Senate’s proposal pass, we think it could strengthen the appeal of the tax-advantaged income available from munis for taxpayers in high-tax states.
Top marginal income tax rates by state
Source: TaxFoundation.org, as of 3/9/2017.
House bill could constrain supply of some munis
The House bill would eliminate the ability to issue private activity bonds (PAB) after Dec. 31, 2017. Private activity bonds 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 bill were to become law in its current form, it could hit muni issuance. Decreased issuance combined with only somewhat lower tax rates for many individuals would likely push muni yields down relative to Treasuries. Issuers that historically have used PABs would likely have to find alternative financing options, such as issuing taxable bonds instead of tax exempt bonds.
Research firm Municipal Market Advisors said this kind of change could lead to an increase in defaults for smaller local area issuers, such as rural hospitals, because eliminating their ability to issue tax-exempt debt could raise their borrowing costs.
Demand for munis from banks and insurance companies could shrink
A drop in the corporate tax rate could also affect demand for munis, particularly from banks and insurance companies. Over the past 20 years, banks have steadily increased their ownership of municipal bonds. Combined with insurance companies, they own roughly 29% of all outstanding municipal bonds.1 Banks and insurance companies buy munis for various reasons, including cash management needs and to help cover long-term obligations. A portion of the interest income for some munis held by banks is exempt from corporate income taxes.
We don’t think banks and insurance companies would liquidate their muni holdings if corporate tax rates fell, but they could scale back their demand, which could make munis more volatile relative to Treasury bonds.
Repealing AMT could cause prices of some munis to increase
Approximately 3.5% of all investment grade-rated munis are subject to AMT, and they yield on average about 30 basis points more than bonds that are not subject to AMT.2 Investors who are subject to AMT and purchase these bonds have to pay the AMT rate on the interest income. This is unlike most munis where the interest income is fully tax exempt.
If AMT were repealed, in theory the yields on these bonds would fall because their non-preferential tax treatment would be eliminated. However, things have been different in practice. Yields for 10-year AA-rated bonds subject to AMT are still trading near their average spreads with munis not subject to AMT.
The benefits of munis go beyond taxes
The benefits of munis go beyond tax savings alone. Even if tax reform becomes law, we believe that munis will continue to be beneficial for many investors due to their tax benefits as well as their generally high credit quality. They have historically defaulted far less frequently than corporate bonds: Only 1% of the entire muni market defaulted for the first time this year, according to Municipal Market Advisors.
What to do now
Although tax reform has the potential to affect the municipal bond market, we don’t suggest investors make significant changes to the portfolios now. The bills face a difficult path forward and could change significantly as they work their way through the legislative process. Even if tax rates are lowered and issuers are impacted, municipal bonds will still offer benefits for many investors, including higher-income earners, in our view.
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.
1Source: Securities Industry and Financial Markets Association, based on Q2 totals as of 9/22/17.
2Source: Bloomberg, as of 11/10/17. Bonds were rated investment grade by either Standard &Poor’s or Moody’s.