From BlackRock: Peter Hayes discusses the impact tax reform could have on municipal bonds, and sees munis maintaining a unique, and coveted, tax advantage.
Tax reform is high on the agenda of the new administration, leading to speculation about what changes could mean for the outlook for tax-exempt municipal bonds. The two areas of focus: A reduction in tax rates for both corporations and individuals, and the elimination or capping of muni tax exemption.
Lower individual taxes … and a grain of salt
The hard truth: Lower individual tax rates reduce the value of a municipal bond’s tax exemption. For example, a drop in the top tax rate from 43.4% to 33% means $4,340 in annual savings would be reduced to $3,300. And to the extent that lower tax-exempt benefit mutes the demand for municipal bonds, market valuations could suffer.
To that salty dose of reality I would add two important provisos:
Tax exemption not dispensable
The tax exemption of municipal bond interest is a key draw for issuers. And while it may be deemed alterable, we don’t see it as dispensable. States and municipalities rely on municipal debt as a low-cost, efficient way to finance capital improvements and fund infrastructure. The federal government hurts itself if it impedes state and local ability to create jobs, sustain their economies and improve the quality of life for Americans. As such, we see the elimination of muni tax exemption as highly unlikely.
Other proposals center on capping the tax exemption at 28%. The odds of such an outcome are anyone’s guess.
Importantly, however, our analysis suggests that any market correction to overcome a 28% cap on the tax exemption, or a drop in the highest tax rate from 43.4% to 33% for that matter, would be manageable. By our estimates, the market might need to offer some 15 basis points (front end) to 50 basis points (long end) in higher yield to compensate for the reduced tax benefit. See the chart above. The market has digested adjustments of this magnitude in the past without a material change to the overall demand dynamic.
Corporate tax reform as an offset
Notably, corporate tax reform could be an important offset to any or all of the above. Current law allows companies to deduct interest payments on bond income. Under reform proposals, that benefit may be repealed to compensate for lower corporate tax rates. This could conceivably lead to lower corporate bond issuance. Munis, in turn, would become a greater source of supply for income-seeking investors. The associated uptick in demand would mute the effect of other tax changes.
There’s another wrinkle, however: The impact of corporate tax reform could vary for banks and insurance companies (relatively large holders of munis) depending on where corporate rates settle and what happens to the Alternative Minimum Tax, or AMT. This could have a negative impact on their need for municipal bonds.
Ultimately, “tax reform” is a series of potential scenarios featuring many variables and offsetting factors. Which reforms are implemented and to what degree will determine the extent of the market impact. Uncertainty is perhaps the only certainty. But this we can say with enough confidence: Munis will retain some tax-exempt benefit—and there will always be an appetite for that very unique feature in an investment asset.
The iShares National Muni Bond ETF (NYSE:MUB) was unchanged in premarket trading Monday. Year-to-date, MUB has gained 0.25%, versus a 3.57% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of BlackRock.