Refresh yourself on the calculation for tax-equivalent yield and learn why it matters given the new tax rules.
Hello this is Natalie Baker, vice president of marketing here at Breckinridge and welcome to the Breckinridge podcast. Today, I am joined by two senior members of Breckinridge's investment team to discuss the Tax Cuts and Jobs Act released last week from the House. Adam Stern, co-head of research, will lay out some of the key provisions of the act and highlight some of the supply, demand and credit impacts, while Matt Buscone, co-head of portfolio management, will discuss the trading and market implications. So, Adam, let us start with you. So, what was in the bill that is meaningful to muni investors?
So, the bill is long. There are a lot of pieces in there, over 400 pages, but certainly there are four or five items that that we think are important to think about for muni investors going forward. I think the key thing to start off with is just to remind everyone all the changes would be prospective. So, they do not affect tax-exempt interest that is out there in the market there, or outstanding bonds. It would be that all these provisions would affect bonds issued after December 31st of this year, 2017. But what are some of the key provisions we are thinking about? Well first, is the elimination of the tax exemption to private activity bonds beginning next year. A private activity bond has a fairly technical definition for the tax code. So, it is anything where a 10% of the proceeds are used in a private business use and 10% of the principal interest payments are secured by property used in a private business. It also includes any bonds where more than 5% of the proceeds are subsequently linked to a non-governmental borrower or more than $5 million is linked to a non-governmental borrower.
The take away for investors that Breckinridge works with is that this includes a subset of the market where they might want to invest and that includes nonprofit hospitals, private higher education universities, it also includes some water revenue bonds sometimes, airports, redevelopment deals. It is really a reasonably large portion of the market. Another area that the bill tackles, which is definitely important to be aware of is the tax exemption for advance refundings. So, starting next year, issuers could not refinance bonds before their call date, the typical call date is 10 years in the muni market, unless they want to do with taxable bond. So that is going to reduce the size of the market a bit. The bill also eliminates the state and local tax deduction, which is a big deal, with the exception of up to $10,000 in local property tax that can be deducted and then make some rate changes, of course. So, it cuts the corporate income tax rate to 20% and it keeps the top personal income tax rate at 39.6%, but it moves up where that rate starts. So, it used to start at about $480,000 for a married couple. It now starts at $1 million, or would start at $1 million under this proposal.
Okay, so you’ve talked about quite a few changes here. Were any of the contents of the bill a surprise, or was everything pretty much expected?
Yeah, good question. So, the state and local tax provisions, frankly were pretty well-telegraphed. That has been bandied about in the press for few months and I think lowering corporate rates and you know, having a top rate maybe a little lower than where it is now, maybe the same. I think for a few weeks that was also pretty well understood. But the elimination of tax-exempt financing for private activity bonds and the disallowance of the tax exemption for advance refundings, you know, that was a big surprise for the market. So just to give listeners some perspective, I mean just about a week or two ago, The Bond Buyer, our industry newspaper, was running an article quoting Kevin Brady, the House Ways and Means chair, saying that there is strong bipartisan support for preserving the tax exemption. The president, of course, over the last several months since the election has also reiterated his support in meetings with various stakeholders for the tax exemption, very supportive of infrastructure spending. The Government Finance Officers Association which represents issuers, you know, they are on the hill. There have been over 90 meetings their lobbyists reported, and this kind of proposal had not come up. So, it certainly was a bit of a surprise in that way. I do think it is important to recognize the bigger picture. I mean Breckinridge has been concerned actually for quite a while, for a few years, that a meaningful change to the tax code as it applies to tax exempt bonds was coming. And we have written about this in a number of different contexts in our annual credit outlooks or in white papers on the tax exemption from a few years ago when we had the fiscal cliff debates. But the bottom line is if you look at the federal government's books, deficits, keep growing, right? So, what does that mean? There is more incentive to push down costs in the states, and there is more incentive to have a tax competition between states and the federal government and this is certainly an example of that. Taking away the ability to issue tax exempt bonds increases revenue for the government and makes financing infrastructure more costly for lower levels of government. Income inequality is high, right, so the federal government has got to pay for these deficits. Who should bear the cost? Certainly, the political support for tax-exempt bonds that benefit high income persons is not really a political winner. You couple that with what we saw in 2009/2010 with BABs and the success of that program. You know for a long-time people said well taxable bonds cannot work in the muni market. Well, we now know that they can. BABs is a proven market, so we can intermediate the infrastructure markets in this country with taxable bonds.
And then I think the other thing to think about is there is a large pool of private capital out there that is interested in investing in infrastructure. You see this with the uptick in discussions about a P3's, public-private partnerships, you see it with an uptick in foreign participation in our market. It is still low, it is like 2.6% of the market, but it is up from less than 1%, you know, a decade ago or so. And certainly there is an asset liability matching function there with you know, long-duration pension funds that do not benefit from tax exemption wanting to buy longer duration assets like a bridge or toll road or what have you. So, you add all that together, it has seemed to us that risks for the tax exemption have been elevated for quite some time and are likely to stay elevated and it is certainly one reason why Breckinridge has made a concerted effort to develop a crossover functionality in our investment accounts. We just think there is going to be more opportunity for crossover buyers in both directions really.
I see. Well, you have talked about some of the eliminations, the elimination of the tax exemption for private activity bonds, etc. It sounds like the market is shrinking, but on the other hand on the demand side, rates are supposed to go down for many taxpayers. So, what is the net of all this? What is the impact on supply and demand?
Right, so good question. So, our view is that on net, the market is likely to shrink. On the supply side, it seems pretty clear to us that the size of tax-exempt market will decrease. So private activity bonds account for up to about 20% of the market if you look at the Federal Reserve data. Advance refundings in any given year could be 10 to 40% of the market. JP Morgan came out just the last day or two of with a number that says the combined portion of issuance for advance refundings and private activity bonds is about 27% of the total issuance on average for the last decade, about $105 billion a year. So, if you eliminate those two groups from the tax-exempt market, that means the size of the market is likely to shrink. That should place downward pressure on tax-exempt yields and all things being equal, lower ratios.
On the demand side, you have got a couple trends that are working across purposes and I do not know that we are sure they exactly cancel each other out, but we do not have a high enough conviction view to say demand is moving one way or another. So hence, the big take-away is the market is likely to shrink as supply shrinks. But just some detail on that demand, on the one hand you would have lower corporate rates with this proposal for a 20% corporate rate and that could have some impact on demand from banks and insurance companies. Notably bank demand, banks were about 6% of our market in 2009. They are about almost 15% today. A lot of bank demand we think is intended to be held to maturity, so we do not expect banks to blow out of their positions, but certainly as a marginal buyer they may slow their purchases if this proposal goes through.
On the other hand, it is important to remember you still have pretty high effective federal marginal tax rates. So, you know, remember the top rate stays at 39.6% for the highest earners and while that rate, you know, does not kick in until $1 million instead of the current $480,000 for married couples, it is still true that high earners are still a big portion and going to be a big portion of taxes and muni demand, so that top rate still matters. And then you couple that rate with the elimination of the bulk of the state and local tax deduction and you have an even higher effective federal marginal tax rate in most places. So, for a person in the top tax bracket who lives in a state with a personal income tax, tax equivalent yields for in-state bonds should go up. How these forces play out again is not entirely clear at this point, but we think demand is at least likely to stay in the same range.
Okay let us switch gears a little now and talk about the credit impacts. Does changing the tax code as they proposed it impact credit at all?
Yes, so I think there is there has four general areas to think about there. First the state and local deduction, right? So, a lot of research on this... the state and local deduction subsidizes the cost of state and local government so if you remove it, it makes funding state and local government more costly. The way this plays out, you take California as a good example, the top marginal rate there is 13% but you can deduct California taxes from the federal returns, so the effective rate on that that marginal dollar in California is 8%. It may decrease public willingness to fund infrastructure projects, education initiatives, whatever it is. Second, by creating a reliable supply of taxable bonds and removing PABs from the tax-exempt market, we could see a lot of changes in the market that are slightly less friendly to creditors. So, what I mean by that? I think if you have more private lenders, they tend to be a little more sophisticated, you could put provisions like you see in bank lending, some of these P3 deals that we say, if that were to grow because of the taxable market, can be very, very complicated and have provisions that you do not always see when you are looking at balance sheets. Certainly more bullet maturities is something we could see. Buyers of taxable bonds like to see bullets they do not like to see zero maturities like we have, at least to the same extent of that we have in the muni market.
A third thing you could see, is states just have to change their actual tax codes. A lot of states piggyback their definition of adjusted gross income or their state tax provisions, for example off the federal tax code, and so many states would have to just change what their definitions are if a bill like this goes through, to prevent either a net reduction in tax or taxing their residents too high. And then fourth, there are some real estate changes that we did not really talk about in this podcast, but that could have impact on home values. They generally relate to lowering the amount of a mortgage that qualifies for the mortgage interest deduction and so in some high income, high-priced areas in blue states, it may make owning a high-priced home a little more expensive. On the flipside, it might actually slow turnover in some these high-priced areas as well by reducing the likelihood that somebody wants to sell their house, because if they buy another one, they would not be able to deduct the interest. How that dynamic plays out has yet to be seen, but certainly a market that relies on property taxes to fund a lot of government and back a lot of bonds, home prices are something we pay a lot of attention to.
All right thanks, Adam, you have given us a lot of very significant credit fundamental impacts to think about as well as some technicals in terms of supply and demand that you spoke about earlier. So now let us move on to Matt to talk about some of the market implications. So, Matt, what has happened with muni and Treasury bonds as we look back in advance of the announcement and then since the tax reform was announced last week?
So, prior to the announcement on the tax reform, Treasury yields had been moving higher in the month end, as equities have continued to rally, the risk had continued to perform well based on that promise of tax reform. Shorter maturity Treasury yields had also risen on increased expectations for a Fed rate hike in December. At one point in late October, I think it was on the 26th, the 10-year Treasury reached a high of 2.46% before rallying back into the low 230s. Muni yields have risen as well and slightly underperformed Treasuries, although that was mainly due to a heavier new issue calendar and some modest outflows from mutual funds in the week leading up to that. Since the announcement... so this news broke call it Thursday afternoon or Wednesday afternoon, I believe. Long tax exempt munis have rallied sharply. Those yields lower by call it 15 to 7 basis points on the long end. And the 30- year ratio of a tax-exempt municipal to the government bond is down to 95%.
So, was any of the tax announcement priced in, in your view?
So, if you look back a few years, munis had actually been cheaper due to fear that tax reform would be transformative and would impact municipal bonds in a negative way, and those fears kind of peaked early last December when municipal ratios to government bonds were north of 100 percent across our entire yield curve. Now as you go through this year, municipal ratios to Treasuries have moved substantially lower as the market had really priced out the possibility of any tax reform that was going to be very negative for municipal bonds. As the bill got closer, as Adam had mentioned, the market was expecting the elimination the SALT deduction and a lowering of the corporate tax rate but neither of those were really expected to have an outsized impact on the market. What was not expected or priced in was the elimination of PABs or the advanced refunding provision, and we have seen that impact the market, particularly on the long end in a positive way.
So, as we look forward, could this proposal mean more volatility in the muni market?
You know, so the big caveat is that we are likely to see changes before this gets enacted. As Adam mentioned, mentioned nobody was really expecting the removal of private activity bonds or the elimination of advanced refundings. So there does exist the possibility that that gets reinstated due to some of the negotiations over the coming weeks, but the volatility could come in a couple different ways and most of that comes through the supply side. We may see an uptick of issuance for the remainder of this year, as issuers look to capture savings via refundings before they go away. Or we may see a rash of issuers come in the private activity market from hospital, healthcare or higher-ed as they look to access the muni market before that window closes. So, you may see a burst of supply in the short-term that may cheapen up the market, but if the bill does pass in this form we are likely to see a material impact on lower new issue supply in 2018 which would likely be a positive for tax exempt muni performance.
All right, well thanks so much, Matt. We hope that you in the field have found this informative and we look forward to you joining us on our next podcast. Thanks so much.
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