The Trump administration released its framework for tax reform in late September, which aims to simplify the tax code by removing certain loopholes and lowering tax rates for individuals and businesses. The framework itself is quite simple, summarized in just nine pages; there's even a “one-pager” on the Treasury's website. The main objectives in the framework that could impact the $3.8 trillion municipal market include:
- Reducing the current seven tax brackets down to three: 12%, 25%, and 35%
- Lowering the corporate tax bracket from 35% to 20%
- Lowering the pass-through rate for Sub S businesses to 25%
- Eliminating the Estate Tax and the Alternative Minimum Tax (AMT)
- Repealing the state and local tax deductions
As of this writing, the market is showing very little reaction to the proposed changes in the tax code. Last November, we published a brief on the impact that Trump's tax policies might have on the municipal sector. The framework provides additional detail, but there are still more questions than answers. What we do know is that, on the margin, lower tax rates should imply less demand for tax-exempt income. The math of it is quite simple. Figure 1 shows the increase in the net yield for municipals under the proposed tax rates that is necessary to earn the same tax equivalent yield (TEY). Here, we assume a 2% net yield as our starting point, which produces TEYs at today's tax rates of 2.98% and 3.53% for C-Corp and Sub S banks respectively. If investors demand the same TEY under the new tax rates of 20% for C-Corps and 25% for Sub S banks, net yields would need to be 40bps and 65bps higher, all things equal. But all things aren't equal. Future changes in supply, spreads, and credit quality are just a few of the many unknowns.
Figure 1: Changes in Municipal Yields at Lower Tax Rates
Figure 2 shows a 1-year history of net yields for Bloomberg's 10-year AAA Bank Qualified Municipal Bond Index. After the election, muni yields sold off by more than 100bps. This reflected the market's expectation that tax reform would be a priority for the Trump administration. Fast-forward to today and yields have erased about 60bps of that move.
Figure 2: Bloomberg's 10-year AAA Bank Qualified Municipal Bond Index
As I noted last November, banks represent a relatively small percentage of municipal bond holders (Figure 3 below). Through the end of 2016, banks held 15.7% of municipal bonds outstanding. In the retail sector, individuals and mutual funds held 70.2% through the end of last year. However, the increase in bank holdings over the past decade has nearly doubled. Given that banks would see the largest tax rate reductions, there's a possibility that at least some banks will reduce their municipal holdings.
Figure 3: Municipal Holders 1996 - 2016
Passage of tax reform faces many hurdles. President Trump has already said he'd leave it up to Congress to determine what the top tax rate should be. Some have speculated that would include adding a fourth bracket for the highest wage earners. Moreover, the elimination of state and local tax deductions would be a negative for municipal issuers, so we'd expect pushback from both sides of the aisle on that front. One positive for municipal holders would be the removal of the AMT. This would bring back many buyers of munis that were previously out of the market for munis subject to the AMT. These bonds, largely issued by airports and housing developers, generally trade at a discount to traditional tax-exempt municipals but would rally if the AMT is eliminated.
At this point, there is a great deal of uncertainty surrounding the impact to the municipal market under the current tax reform framework. If tax reform gets through the House and Senate, there's a high probability that we'll see changes to the plan under its current form. Municipal investments have long provided attractive yields for banks relative to alternative sectors of the same credit quality, and should remain so under lower tax rates. However, municipal investors should continue to monitor potential changes to the tax code that might impact their appetite for tax-exempt income.
Simmons is senior vice president at The Baker Group, a WBA Bronze Associate Member. He works with community bank needs pertaining to interest rate risk, asset/liability management, and fixed income portfolio management. He created the firm’s municipal credits database, and is a frequent speaker at banking schools and financial seminars. He can be reached at 800/937-2257, drew@GoBaker.com.