If as an investor you are reluctant to take part in the intricacies of the stock market and you want to preserve your capital and earn tax-free income, then look no further than municipal bonds.
One of the main reasons why investors in high tax brackets usually gravitate towards muni bonds is their tax exemptions at the federal level, and in many cases at state and local levels as well – this is typically known as a triple tax exemption. However, how will muni markets and investors be affected by all the political turmoil under the new administration and expected changes in economic rules and regulation?
We aim to address this question through this article.
Taxable vs. Tax-Free Municipal Debt
Before diving into the proposed tax reforms and their impact, it’s important to briefly look at taxing entities and their ability to issue various forms of debt. While municipalities have the potential to issue muni bonds in both taxable and tax-exempt forms, investors usually place their bets on tax-exempt muni issues for the obvious tax benefits. Meanwhile, investors in taxable municipal debt always seek a higher yield (also known as a tax-equivalent yield) on their investments to compensate for the tax burden.
Before we dive further into proposed tax reforms, you can read the proposed tax reforms.
Proposed Tax Reforms and Potential Impact on Municipal Markets
Let’s take a closer look at how the new tax plans can shape the municipal markets in upcoming years. The new administration has highlighted a couple key reforms that will be crucial for investors.
One of the main reforms is bringing down the marginal tax rate (MTR) for high earners. MTR is defined as the tax applied to your income, which progressively increases as your taxable income increases; yet it doesn’t reflect your overall tax bracket because different a tax rate is applied to different portions of your income.
Currently, the highest rate in the marginal tax bracket is 39.6%, which hits taxpayers with an adjusted gross income of $406,751 and higher (for single filers) and $457,601 and higher (for married filers). This means that any taxable income above this threshold must be taxed at the the highest tax rate of 39.6%. However, under Trump’s proposal, the highest MTR will be brought down to 33%, which in turn benefits high earners tremendously on their tax bill.
As mentioned earlier, wealthy investors have always looked to lighten their tax burden on investment income through muni bonds. If the tax bracket for high earners is lowered, muni bonds may become less attractive because of the tax value loss. This in turn will push the muni bond yields to increase to compensate for the loss. The illustration below shows a perfect relation between tax-equivalent yield and tax-free yield to help you understand the complexity of tax-rate change.
- Tax-Equivalent Yield = Tax-Free Municipal Bond Yield / (1 – Tax Rate)
Let’s suppose an investor with an average tax bracket of 33% who has invested in a taxable vehicle (consider the Illinois St Taxable Pension bond) earning a 5.10% coupon. Now, when we take his tax obligation into account, his actual earnings are 3.42% – i.e., the tax-free yield. In other words, if this investor finds a municipal bond paying 3.42%, it is equivalent to him earning 5.10% on a taxable bond.
Now, what happens when the tax bracket changes? In that same scenario, when we change the tax rate from 33% to 30%, the same 5.10% taxable return is now equivalent to a 3.57% tax-free yield, suggesting that muni bonds will be less attractive. This also means that taxable bonds and other corporate bonds that tend to pay higher yields than tax-free munis will become relatively more attractive for investors.
Therefore, reducing tax brackets also reduces the tax benefits offered by tax-free investment vehicles.
Another major reform expected to take shape is the repeal of the AMT clause, which entails tax-exempting the earnings from certain debt instruments that otherwise would be taxed. Check our Muni Bond glossary to familiarize yourself with various muni bond terminologies.
PABs tend to fall under this criteria, where earnings from them can be subject to AMT. PABs are generally issued by local and state governments, by forming partnerships with private enterprises to take on major projects. Given President-elect Trump’s election focus on reviving the American infrastructure, there is a high likelihood that this would translate into spending closer to the proposed $1 trillion on infrastructure over the next 10 years and providing $137 billion in tax credits to private enterprises.
The AMT exemption serves as a plan to fix the infrastructure by promoting private-public partnerships and making PABs tax-free instruments. In recent years, PABs have garnered a lot of attention for their attractive returns. If the AMT exemption materializes, the demand is likely to increase even further, thus bringing down the yields.
Explore our Market Activity section to view the most recent muni trades.
On a similar note, taxable BABs could become the right vehicle for foreign investors to put money in U.S. infrastructure projects. The new administration has already signaled interest in reinvigorating BABs to stimulate the economy and create more jobs.
Key Considerations for Investors
It is very important for investors to monitor the municipal markets as new tax reforms unravel. Currently, where short-term muni bonds and notes will provide stability from the interest rate risk in your portfolio, it’s also important to keep an eye on enterprise debt (e.g., water and wastewater projects,) and PABs from a long-term investment perspective. Given the proposed reforms, it is also important to note the following:
- Muni debt yields will rise to make up for the tax value loss and decrease in demand from high earners, and municipal entities issuing debt for local projects may have to face higher costs to fund their projects.
- Short-term debt has already emerged as a safe haven compared to longer-term counterparts for many investors looking to protect their portfolios from interest rate hikes.
- Municipalities will have to think hard about enhancing their revenue streams (e.g., water rate increases for enterprise debt) to keep up with the bond covenants.
Under the proposed tax reforms, it’s pretty evident that municipal markets are at a pivotal point. From the proposed marginal tax rate reduction for high earners and AMT exemptions, to bringing back BABs and promoting PPPs, every policy is likely to motivate investors to look for higher yields that can make up for tax value losses.
While muni bonds are expected to serve as a driving force funding U.S. economic growth, it will become more expensive for municipalities to issue muni debt because of a potentially weaker demand and the urge to seek higher coupons.
Visit our Tax Education section to stay up to date with muni taxation reforms.