Fixed Income

How Trump's Tax Proposals Could Affect the Municipal Bond Market

How Trump's Tax Proposals Could Affect the Municipal Bond Market
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The Trump administration’s tax proposal, which calls for lowering the corporate tax rate to 15% from 35%, as well as dropping the top marginal federal rate to 35% from 39.6%, has been greeted with indifference by the municipal bond market thus far.

Both the municipal and Treasury bond markets have taken the announcement in stride with rates and ratios changing only slightly. We assign a low probability to the passing of a corporate tax-rate reduction to 15% and markets seem to agree. The administration’s proposed tax-reform package and market impact bears watching closely, however, as it winds its way through the legislative process.

Perhaps the most impactful part of the plan calls for lowering the corporate tax rate to 15%. This proposed cut in the corporate rate is significant as the lower tax rate would reduce the appeal of tax-exempt bonds for the insurance companies and banks that hold 14% and 15% of outstanding municipal debt, respectively. Standish believes that while demand from these institutions could decrease gradually as a result of this lower tax rate, widespread selling is unlikely. Accounting conventions should keep insurance companies from rapidly selling off municipal bonds and the favorable risk/reward and liquidity characteristics of these bonds continue to make them attractive investment propositions.

KEY ATTRIBUTES: TAX-EXEMPT VS. TAXABLE MUNICIPALS

Other provisions of the Trump tax proposal offer even less chance of disrupting the municipal bond market. A proposed cut in the top individual income-tax rate from 39.6% to 35% would likely have a negligible impact. Previous cuts to top marginal rates, such as those enacted during the Ronald Reagan and George W. Bush administrations, had no discernible impact on municipal bond pricing; also, historically municipal bond yields have consistently been higher than the prevailing implied tax rate relative to Treasuries.

Within the tax proposal, the call for phasing out of some deductions—1) state and local taxes from federal taxable income and 2) removal of the alternative minimum tax (AMT)— could have implications for select municipal bonds. We see the potential loss of these deductions raising demand for tax-free municipal bonds from U.S. individuals in high-tax states such as California, New York and New Jersey. Furthermore, municipal bonds subject to AMT provisions could get a price boost as those rules are eliminated.

In the event that corporate bondholders reduce their municipal bond exposure as a result of tax reform, which could pressure yields higher, we would view this as a buying opportunity. Furthermore, we believe some allocation to taxable municipal bonds can provide a hedge to the potential outcome of these proposed lower tax rates. We believe that regardless of what happens with tax reform, taxable and tax-free municipal bonds deserve consideration for investment portfolios of both U.S. and non-U.S. investors alike.

RISKS

Bonds are subject to interest-rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. Municipal income may be subject to state and local taxes. Some income may be subject to the federal alternative minimum tax (AMT) for certain investors. Capital gains, if any, are taxable. The amount of public information available about municipal securities is generally less than that for corporate equities or bonds. Legislative changes, as well as state and local economic and business developments, may adversely affect the yield and/or value of municipal securities. Other factors include the general conditions of the municipal securities market, the size of the particular offering, the maturity of the obligation, and the rating of the issue. Income for national municipal funds may be subject to state and local taxes. Income may be subject to state and local taxes for out-of-state residents.

The Bloomberg Barclays U.S. Corporate Investment Grade Index is an unmanaged index consisting of publicly issued U.S. Corporate and specified foreign debentures and secured notes that are rated investment grade (Baa3/BBB or higher) by at least two ratings agencies, have at least one year to final maturity and have at least $250 million par amount outstanding. The Bloomberg Barclays U.S. Municipal Bond Index covers the USD- denominated long-term tax-exempt bond market. The Bloomberg Barclays U.S. Taxable Municipal Bond Index covers the U.S.-denominated long- term taxable municipal bond market. Bonds must have an amount outstanding par value of US$7mm, issued as part of a transaction of at least $75mm. Bonds must be rated investment grade using the middle rating of Moody’s, S&P and Fitch; when a rating from only two agencies is available, the lower is used; when only one agency rates a bond, that rating is used.The Bloomberg Barclays 10-Year U.S. Treasury Index is a universe of Treasury bonds, and used as a benchmark against the market for long-term maturity fixed income securities. The index assumes reinvestment of all distributions and interest payments.

This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular investment, strategy, investment manager or account arrangement. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Please consult a legal, tax or investment advisor in order to determine whether an investment product or service is appropriate for a particular situation. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. The Dreyfus Corporation, Standish Mellon Asset Management Company LLC (Standish) and MBSC Securities Corporation are companies of BNY Mellon. ©2017 MBSC Securities Corporation, Distributor, 225 Liberty Street, 19th Fl., New York, NY 10281.

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