Tax Reform and the Muni Market

Deidra 2016-11.jpg

by Deidra Krys-Rusoff
Senior Vice President

Week in Review

Stocks climbed in the U.S., Asia and Europe as the U.S. government averted a shut down and the jobs report reinforced optimism. The U.S. added 228,000 jobs in the month of November, higher than the expected addition of 195,000 jobs, due to an accelerating hiring trend which economists expect to continue into the next year. The S&P 500 hit new highs today, trading above 2,650. 10-year U.S. Treasury bond yields remained mostly unchanged from last Friday, yielding around 2.37 percent. Next week will be a busy financial news week, with Fed policy makers projected to raise the Federal Funds Rate as well as consumer inflation and retail reports that are scheduled to be released.

Tax Reform and the Muni Market

Tax reform is making headlines, but questions abound. What will the new individual and corporate rates be? Will individuals be able to deduct state and local taxes from their federal taxes? How will the new standard deduction play out? The stock market continues to advance, despite this policy uncertainty. However, the uncertainty is creating extreme volatility in the municipal bond market.

The municipal bond market was surprised by the proposed tax reform bills from both the House of Representatives and the Senate. Each bill contained repeals that create sweeping changes for the ways that state and local government finance capital projects.

If Congress were to pass the House bill, it would repeal advance refundings of municipal bonds and private activity bonds. Advance refunding of municipal bonds is a process similar to refinancing your mortgage: if a municipality can refinance an existing loan for a lower rate, it can issue new bonds for the same project and refund the old bonds with the new proceeds. Private activity bonds are tax-exempt municipal bonds issued for projects that are believed to advance the public good. These include hospitals, higher education, student loans, veterans housing, airports and other such entities. The Senate bill contains only the provision to repeal advance refundings. These repeals are proposed to help Congress pay for the corporate and individual tax relief.

How are these proposed changes affecting the municipal market today?  Municipalities fear that tax reform will remove some of the relatively inexpensive means to finance capital projects. If the final reform package disallowed the issuance of advanced refundings and private activity bonds, overall municipal bond issuance would drop by 30-40 percent. This has motivated many municipalities to move planned advance refundings and private activity bond sales forward from January and February, while these bonds are still federally tax-exempt.  The large, unexpected additional supply has had the impact of lowering prices and increasing yields. This will be followed by significantly decreased issuance in January and February, which generally results in higher prices/lower yields. Some investors are actively investing in municipal bonds to take advantage of this supply disruption.

Takeaways for the Week

  • November’s job report numbers were stronger than expected
  • The S&P 500 hits new highs, again
  • Tax reform creates volatility for the municipal bond market