Municipal Bonds: Tax Reform Rocks the Muni Market

We focus on quality as the effects of unintended consequences from the tax overhaul loom large.

February 23, 2018


This Municipal Bonds sector report is excerpted from the First Quarter 2018 Fixed-Income Outlook.

Since the first tax reform bill was proposed in November 2017, the municipal market has been fixated on provisions that would directly and indirectly impact tax-exempt municipal bonds. Not surprisingly, December 2017 generated $62.5 billion of new-issue supply, an all-time monthly record, as issuers reacted to proposals surrounding qualifications for tax-exempt issuances. This highlights once again the outsized influence of federal policies on municipal bonds. The elimination of advance refunding bonds immediately reduces upcoming years’ supply expectations.

Advance Refunding Dropped in 2017 from 2016 Peak

The elimination of advance refunding bonds will immediately reduce supply expectations. Further, a lack of alternative financing options may encourage issuers to revisit strategies of using derivative contracts to manage interest rate risk.

Advance Refunding Dropped in 2017 from 2016 Peak

Source: Thomson Reuters, Guggenheim Investments. Data as of 1.25.2018.

Behavioral changes in response to the tax plan may ripple through the market’s composition and credit quality. For example, increases in federal Medicaid funding, on which state and local governments have become increasingly dependent, may prove difficult to maintain given projected federal budget deficits. The $10,000 cap on state and local tax (SALT) deductions may enhance the relative value of tax exemption, but more migration from high-tax states to low-tax states would reduce the municipal market’s natural demand base. From a credit quality perspective, such migration will also impair the financial flexibility of high-tax municipalities.

The Bloomberg Barclays Municipal Bond index posted a 0.8 percent gain during the fourth quarter of 2017, with longer-maturity bonds continuing to outperform the short end and lower-quality bonds outperforming higher quality. BBB-rated and A-rated municipal bonds returned 1.4 percent and 0.9 percent, respectively, versus 0.7 percent for AA-rated bonds and 0.5 percent for AAA-rated bonds. Municipal bonds were up 5.5 percent for the year.

In order to soften supply reductions, investment bankers may be prompted to deliver comparable financing solutions with non-standard features (e.g., shorter calls, non-5 percent coupons). Further, a lack of alternative financing options may encourage issuers to revisit strategies of using derivative contracts to manage interest rate risk. The municipal market’s changing dynamics are highlighted by the preservation of private activity bonds (PABs). Although PABs were eventually saved by a narrow margin, the legislative process underlined that unique features cherished by the municipal market are not sacrosanct. We continue to emphasize uncovering value through credit fundamentals.

SALT Deductibility Limits Will Reshape the Muni Market

State and local taxes as a percentage of total personal tax liability and income.

The $10,000 cap on state and local tax deductions will likely incentivize more migration from high-tax states, such as Connecticut and New Jersey, to low-tax states, such as Florida and Texas. Such migration would reduce the municipal market’s natural demand base and, from a credit quality perspective, will also impair the financial flexibility of high-tax municipalities.

SALT Deductibility Limits Will Reshape the Muni Market

Source: Internal Revenue Service, Guggenheim Investments. Data as of 1.25.2018.

—James Pass, Senior Managing Director; Allen Li, CFA, Managing Director

 
Important Notices and Disclosures

This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.

Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. ©2018, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.


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