Participants in the municipal market—issuers, investment bankers, investors and others—are uniformly concerned about the potential for market damage from the implementation of a variety of tax changes under consideration by President-elect Trump. A tax bill is expected to be a major priority of the Trump Administration and a focus of the first 100 days.
Proposals under consideration include reductions in both corporate income tax rates and personal income tax rates, as well as the elimination of the surtax on investment income. While lower marginal tax rates are universally supported by economists as beneficial in promoting stronger economic growth (with the possible caveat that lost revenues are recovered through expenditure reductions over the long-run), lower tax rates are problematic for municipal bonds since they alter the relative pricing of tax-exempt bonds and taxable alternatives.
When lower marginal tax rates raise the after-tax yields on Treasury securities, municipal yields must rise to offset the increase in the after-tax advantage of Treasury bonds to the detriment of municipal bond issuers and investors. The compensating rise in tax-exempt rates imposes higher financing costs on the states and cities financing infrastructure. Additionally, investors in municipal bonds are hurt since their existing holdings lose relative value to Treasuries, forcing prices to adjust adversely.
Analysts wanting to quantify the impact on municipal yields pending a proposed cut in tax rates typically have relied upon a static calculation of the difference in after-tax yields applicable to the Treasuries, while assuming that municipal yields must adjust on a corresponding basis-point for basis-point basis. These calculations provide dramatic examples of what issuers will face in higher borrowing costs and how much investors will be hurt in their existing portfolios should the tax law changes go forward.
Unfortunately, the calculations are a simplification of how prices are set in bond markets and should not be relied upon.
Prices in any market adjust dynamically, with new equilibriums established after iterative adjustments in supply and demand schedules. No economist has ever identified exactly how one equilibrium is replaced by another, which is why the French economist Léon Walras (December 16, 1834 – January 5, 1910) created the idea of the "Walrasian Auctioneer," a process by which changes in equilibriums can be explained through the actions of an auctioneer who successfully matches buyers and sellers in all markets to achieve a general equilibrium in all markets. One thing the concept of the Walrasian auctioneer does is to acknowledge the dynamic nature of price setting in markets—notably, that it is almost infinitely iterative and that it is not understood well by economists.
Let's take an example used in this past weekend's (Dec. 17th-18th) edition of the Wall Street Journal in the article "Munis Face a Taxing Turn." The article uses an example of a taxable bond facing the 3.8% surtax on investment income, which would be eliminated presumably by President Trump. It is argued that the elimination of the surtax, which would lower the tax rate facing taxable bonds from 43.4% to 39.6%, would require a 10-year muni yielding 2.37% before the tax change to rise in yield to about 2.55% in order to compensate for the post-tax change after-tax improvement in the taxable alternative.
The calculation is simply the after-tax yield on the taxable investment before the change minus the after-tax yield after the tax change. The problem comes when the assumption is made that the muni yield would have to rise exactly the same amount to re-establish the original demand "equilibrium."
The problem with this logic is that it makes an implicit assumption that is wildly inaccurate: namely, that the municipal to taxable yield ratio is set originally at a tax-efficient point that makes the muni yield equivalent to the after-tax taxable yield. Without this assumption, it is not the least bit obvious that municipal yields would rise by the difference in after-tax yields of their taxable counterparts.
Using an accurate example, the current 10-year Treasury is yielding about 2.54%, while the 10-year MMD AAA Muni is 2.48%. Instead of the implied ratio of 56.6% used in the jerry-rigged example, the actual market relationship of the two yields is 97.6%. The after-tax yield on today's Treasury is 1.44% at 43.4% and rises by almost 10 basis points, if the tax is cut (as before) to 39.6%, to a yield of 1.53%.
With the muni yielding 2.54%, it is preferred to the Treasury before and after the tax cut, although its relative advantage decreases slightly from about 100 basis points to 90 basis points. How strong is the assumption that the muni must rise by 10 basis points to offset the improvement in the Treasury's yield now?
While muni professionals would love to stave off – or at least alert market participants to – tax changes that are adverse to the issuers and investors in our market, the commonly used examples do not stand up to scrutiny when using actual market interest rates. Using bogus examples of how tax changes impact munis may be adverse to our own interests when trying to win the hearts and minds of the Treasury Department, or the wonks on the tax writing Committees of the House and the Senate.
Why are examples like the WSJ example counterproductive?
- Municipals and Treasuries are segmented markets purchased by different investor groups facing different tax rates. Given the different numbers and categories of investors that operate in each market (recognizing that many investors do buy in both markets), and that they face different tax rates, or sometimes no tax rate at all, it is not hard to imagine that a change in the taxable market does not likely translate into an identical yield change in the muni market. Pension funds are large buyers of Treasuries, pay no taxes, and buy few, if any, tax-exempt bonds. Banks as well as insurance companies face different tax rates within their own industry and relative to other sectors. Individual investors in munis are not confined to the highest marginal tax bracket.
- The static example fails to address the reality that the benefit of lower taxation on taxable bonds increases their yield and subsequently boosts demand, further increasing their price and offsetting some of the tax-change created yield advantage. As with the Walrasian Auctioneer, this is an iterative and dynamic process. So, the rise in muni yields attracts new investors who previously failed to find them attractive, but now may. And the process of adjustment goes on.
- Examples that do not use real-market examples reflecting munis' actual relationship to Treasuries should be questioned. The 39.6% marginal tax bracket has been in effect since the beginning of 2013, yet the muni to treasury yield ratio has averaged 94.85%. We have already seen that when munis are cheaper than an assumed point of tax efficiency between themselves and Treasuries, it is far from obvious that they will adjust in lockstep to changes in after-tax taxable yields.
- Perhaps most importantly, munis are never priced efficiently at a yield that represents the difference in tax-treatment. History has shown consistently that supply and demand influences, the level of interest rates, and the perceived value of all investment opportunities available to investors, including stock, commodities, and everything else, exhibit influence on the relative pricing of munis to Treasuries that overwhelms the simple static calculation of the impact of a change in marginal tax rates when viewing the markets in isolation.
Statistically, changes in municipal to Treasury yield ratios explain only 2.8% of the difference in Lipper flows into municipal mutual funds, a common proxy of municipal demand. The relationship is statistically significant at the 5% level, but still clearly shows that relative pricing of municipals to Treasuries is only a minor component in explaining the demand for mutual funds. Similarly, a regression using the yield ratio as the dependent variable and the prevailing marginal tax bracket as the independent variable explains only 2.7% of the movement in Muni/Treasury ratios. The fact is that munis are a complicated market where prices are set under a broad set of supply and demand influences. Using examples that start with propositions that are at considerable variance to real-world observation does not help in untangling the dynamic impact of changes in one or more variables that influence price-setting.
The insistence on evaluating changes in tax law using idealized and generally unobserved Muni to Treasury yield relationships overstates the impact of the marginal tax impact. This not only provides an unrealistically negative view to investors and issuers of the outcome of a possible tax change, but undermines the potential influence of municipal market advocates in Washington.
Christopher Mier is managing director of the Analytical Services Division at Loop Capital Markets
