Federal Tax Reform and Its Impact on the Municipal Bond Market

Introduction

The municipal bond market will feel the impact from a supply, structural and credit perspective as the Tax Cut & Jobs Act takes effect. Investors in high tax states will be taking a closer look at municipal bonds, now that state and local tax, or SALT, deductions will be capped at $10,000 a year. On the one hand, the maintenance of the tax-exemption on municipal bonds, along with the SALT cap, can make these bonds more attractive for certain individuals in high tax states. On the other hand, municipal issuers and their investment bankers will likely deal with greater spending burdens and limited refinancing options by creating new debt structures.
 
Balancing the federal budget in the wake of the $1.5 trillion Tax Cut & Jobs Act could mean restructuring Federal safety net programs, such as Medicaid, Medicare, Social Security, and food stamps. Cuts at this level would place a greater burden on state and local finances, resurrecting proposals that would further impact the municipal bond market.
 
In the interim, here’s a summary of the impact to the municipal bond market:
 

• Loss of Advance Refundings as Tax-Exempt Debt. Advanced refundings are usually structured to refinance older, higher cost debt ahead of the earliest call date. Sometimes they are issued not simply for debt service cost savings, but for debt restructuring or changes in security features.
   
  In Hartford, Connecticut, for example, plans to advance refund to provide debt relief to the financially-burdened city assumed that the state would ultimately guarantee the city’s debt and cover a major share of the city’s debt payments. There may now need to be a new method for the city’s fiscal relief plan.
   
  Other implications for the municipal market with the loss of advanced refundings include:
  • A significant reduction in gross and net supply over the next few years. (Average issuance of tax-exempt advance refunding over the past 10-years was $53 billion accounting for approximately 15% of total issuance). This decline in supply should lead to some price improvement for outstanding debt relative to taxable equivalents.
  • The municipal yield curve could flatten as issuers gradually shift to shorter maturity/bulleted structures with lower coupons increasing supply over long maturity callable bonds.
• A reduction in the corporate tax rate to 21% from 35%. Municipal market buyer participation from banks and insurance companies, which currently hold 23% of the municipal market, could decline significantly. With a reduction in the effective corporate tax rate, after-tax yields on taxable securities will likely increase, reducing the attractiveness of municipals versus corporate bonds. It’s important to note that an abrupt liquidation by corporate holders is unlikely, as sales might generate unwanted tax gains.
• Restrictions on state & local tax, or SALT, deductions from Federal Income Taxes. The Republican tax plan caps the deduction at $10,000 for property, income and sales taxes. (This $10,000 cap isn’t indexed to inflation, eroding its real value over time.) This cap could hamper high-tax states’ and localities’ ability to deal with financial pressures and infrastructure needs by making any plans to increase taxes even more costly to many residents. In the long term, this could detract from the credit quality of high tax states and municipalities, given the increase in the cost of living, lesser disposable income and the potential for population loss over time.
   
  Of course, the tax situation, whether local or state, is only one factor in determining business location and individual living preferences. The SALT provision makes tax exempt bonds from high tax states, such as California, New York, Minnesota and New Jersey, plus those from states with more moderate tax rates but with insufficient supply to meet in-state demand (such as Massachusetts and Colorado) more valuable, especially relative to the bonds of states with lower income tax rates.
• Another restriction is the mortgage interest deduction capped at $750,000 from $1 million and the repeal of the home-equity loan deduction. This could lower home values in high-cost areas, hurting the property tax base for states and localities.
• The preserving of private activity bonds, or PABs – for now. State and local governments issue tax-exempt PABs to finance projects of non-governmental entities that provide a public benefit. This includes borrowings for hospitals, museums, colleges, toll roads/bridges, affordable housing, airports, senior living facilities, charter schools and even certain utilities – and could comprise over 18% of the total municipal market. Elimination would have increased borrowing costs for all these sectors and would have been counter-productive in the next expected major legislative initiative – a national infrastructure program. It seems likely that this national program will use some combination of federal monies, state & local government incentives and increased private sector activity. PABs should play a major role to facilitate various financing approaches but could again be subject to removing its tax-exempt status if Congress decides to help close its budget gap by removing preferential tax treatment.
   
  A subset of PABs is bonds subject to the Alternative Minimum Tax, or AMT, found mostly in public finance in the airport, housing and student loan sectors. While the corporate AMT is repealed, the individual AMT will remain in place with relatively high exemption levels compared with current levels. Consequently there could be some narrowing of the previous spread between AMT and non-AMT debt.
• Healthcare and the elimination of the Individual Mandate. Under the Affordable Care Act, the insurance mandate (which is technically a tax) subjected Americans who don’t have insurance coverage to an annual penalty of $695 or 2.5% of income, whichever is greater. The impact of elimination will likely pressure insurance providers, decrease covered services, and increase bad debt expenses at healthcare providers. It is also expected to lead to higher premiums for people who do not qualify for premium subsidies. Municipal healthcare debt of hospitals or hospital systems that do not have strong balance sheet resources and a dominate market position and/or have a weak payor mix (uninsured or Medicaid patients) will experience continued operating stress.
• A 1.4% excise tax on net investment income for private university endowments for institutions with at least 500 students and assets valued at $500,000 per student. While most of the threats to the higher education sector did not materialize, this excise tax on endowments does affect 35 institutions in the United States that meet these criteria.

 
A 12.5% Puerto Rico manufacturing tax. U.S. mainland companies operating in Puerto Rico are now subject to tax on the income they receive from intellectual property, in line with the treatment of U.S. companies operating in foreign countries. The tax on intellectual property includes patents and design rights and will have a large impact on medical/pharmaceutical manufacturing – a dominant sector in Puerto Rico. This will undoubtedly spur Puerto Rico manufacturers to shift operations to the U.S. mainland to avoid this tax, further complicating the Commonwealth’s recovery.
 
Howard Cure is the Director of Municipal Bond Research at Evercore Wealth Management. He can be contacted at cure@evercore.com.