As President Trump prepares to sign the new tax bill into law, certain aspects of the plan are receiving significant attention, and rightfully so. Republicans are heralding the plan as the largest tax overhaul in three decades. The bill lowers corporate tax rates, realigns individual tax rates, and caps or eliminates certain deductions. In short, it touches most businesses and individuals across the country.

Just as importantly in our opinion, a less-publicized portion of the legislation is also set to impact municipal bond investors in a big way, and is likely to have ramifications for the structure of the market,  credit quality within certain sectors of the market and, in general, the relative value municipals offer versus taxable bonds.

Lower Municipal Supply May Mean Lower Municipal Yields

Specifically, the bill eliminates a popular financing technique municipalities regularly use called advanced refunding. In an advanced refunding transaction, a municipality refinances outstanding debt to save money on interest costs. That is, if borrowing costs have fallen from the time at which a municipality originally issued bonds, that municipality could issue new bonds at lower rates and use the proceeds to retire the original, higher-cost bond issue. We believe the elimination of this financing structure could dramatically lower the supply of newly issued bonds and short-term, pre-refunded bonds in the months and years ahead.

Advanced refunding transactions have represented approximately 15% of municipal issuance over the last few years. By some estimates, 2018 gross municipal issuance will come in at $330 billion in 2018, a big drop from the more than $400 billion issued in 2017.1 Importantly, 2018 issuance will be lower than the amount of bonds maturing during the year, which will create a negative net supply environment. All else being equal, we believe eliminating these transactions is likely to drive up the price, and drive down the yield, of other municipal bond issues – meaning potentially less income potential for investors.  

A Potential Solution: Blending Municipals with Taxable Investment-Grade Bonds

We think investors focused on after-tax yields and improved diversification should consider combining municipal bonds with taxable investment-grade bonds. This is especially true for investors in mid-level tax brackets, or for those that reside in low- to no-income-tax states.

While we have observed the benefits of this combination during the 10-plus years of managing such tax-efficient, blended fixed income strategies, we believe them to be particularly compelling now. With less overall municipal supply, but specifically less short maturity supply (with few pre-refunded bonds) and potentially lower yields, the relationship between short taxable and tax-free bonds should further tilt in favor of taxable bonds in the years to come. Within the taxable universe, we are finding after-tax yields for short-term corporates and taxable municipals to be attractive. Exhibit 1.

Exhibit 1: After-Tax Yields May Favor Taxable Bonds

  Yield Matrix  
IndexDurationCredit QualityYieldAfter-Tax Yield
1-5 Year U.S. Tax-Free Municipal2.42AA31.651.65
1-5 Year U.S. Corporate2.73A32.561.74
1-5 Year U.S. Taxable Municipal2.28AA32.501.70

Sources: ICE and Bank of America Merrill Lynch, as of 12/15/17. Note: Assumes a 32% tax bracket.

We believe the addition of taxable bonds can also provide significant diversification benefits to fixed income portfolios. Exhibit 2 details correlations among various investment-grade sectors.  Lower correlation means less overall portfolio volatility when sectors are combined.

Exhibit 2: Diversification Potential of a Taxable / Municipal Blend

  Investment Grade Correlation Matrix  
 U.S. MunicipalU.S. Treasury and AgencyU.S. CorporateU.S. Taxable Municipal
U.S. Tax-Free Municipal1.000.740.680.81
U.S. Treasury and Agency0.741.000.670.85
U.S. Corporate0.680.671.000.74
U.S. Taxable Municipal0.810.850.741.00

Sources: Bloomberg, ICE, Bank of America Merrill Lynch. Monthly index price correlation from 12/15/09 to 12/15/17.

While the full ramifications of the tax plan will become clearer over time, municipal bond investors have already received a preview. We believe adapting to the environment through a dynamic blend of taxable and municipal bonds may offer benefits to investors focused on after-tax returns.

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  1. ^Sources: Bloomberg, Citigroup, JP Morgan.