In Rochester, it has been our longstanding belief that, over time, income generates the bulk of total return when investing in bonds. For municipal bond investors, the federal tax exemption on the net investment income generated by muni bonds is of the utmost importance. The Tax Cuts and Jobs Act (the Act), effective January 1, 2018, retains that exemption as expected, and for that we are truly grateful this holiday season.

On balance, the Act represents positives for municipal bondholders, but potentially adds additional financial pressure on municipal issuers, specifically in high-tax states. Overall issuance should slow in the first quarter of 2018 because uncertainty surrounding the Act created a huge rush to market in December. Total issuance for 2017 will likely be around $425 billion while many experts are predicting between $275 billion and $300 billion in 2018. This represents as much as a 35% potential decrease in supply.

We do not believe lowering the top federal income tax rate to 37% from 39.6% will curtail individual demand. The $10,000 maximum deduction for a combination of state and local income taxes or property taxes could increase demand, particularly for those who live in high-tax states.

Other developments include:

  • Changes in the Alternative Minimum Tax (AMT). AMT exemption amounts and phase-outs have been increased for individual taxpayers while the corporate AMT is eliminated. We believe this could further tighten spreads between AMT and non-AMT bonds, strengthening the relative value of AMT bonds.
  • Advance pre-refunding of municipal bonds to be prohibited. This cost-efficiency strategy has been used by countless municipal borrowers to take advantage of falling interest rates in the market. In its absence, borrowers will only be able to refinance bonds on their call date instead of pre-refunding them with U.S. Treasuries. This will likely decrease supply in the municipal bond market, at least in the short term. In the long term, this will potentially result in higher borrowing costs and less flexibility for municipal issuers. Tight supply is a positive for existing bondholders. Bond funds, of course, could earn higher levels of income if borrowing costs increase in the future.
  • Continuation of tax-exempt Private Activity Bonds (PABs). These are bonds generally used to finance multi-family and single-family housing projects, airports, infrastructure projects, nonprofit hospitals, and universities. President Trump has promised to introduce an infrastructure plan in January, and many municipal market participants believe PABs could play a role in financing that plan.
  • Corporate tax rate reduction. A 14 percentage point drop in the corporate tax rate, from 35% to 21%, will make municipal bonds less attractive to corporations (Property and Casualty insurers, banks, and non-financial entities). This could potentially decrease demand if taxable bonds provide more after tax yield to corporations than municipal bonds.
  • Mortgage interest deduction reduced. Under the new tax law, individuals may deduct interest paid on mortgages issued after January 1, 2018, up to $750,000, a reduction from the current level of $1 million. This deduction continues to apply to interest paid on second-home mortgages, but not to home equity lines of credit.
  • No changes for capital gains or qualified dividends. Current, income-dependent rates of 0%, 15% or 20% continue to apply.

Investors should consult their tax advisor for details on how changes under the Act may affect their tax liability.

The income produced by muni bonds will remain exempt from federal income taxes; from state and local taxes, where applicable; and from the 3.8% on unearned income, a vestige of the Affordable Care Act (Obamacare). For a taxpayer in the top federal income tax bracket, a muni investment yielding 4% thus offers as much after-tax income as a comparably sized taxable investment yielding 6.8%. (The muni is said to have a taxable equivalent yield, or TEY, of 6.8%.) The muni’s TEY would be even higher for investors subject to state and local taxes.

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