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.