Municipal investors at client meetings with BlackRock are expressing more concern about rising interest rates than about the potential impact of tax reform – to the surprise of officials in the firm's muni group.
"With all the uncertainty with munis and how it relates to tax policy, you would think that would be first and foremost on investors' minds, but it's actually not," Peter Hayes, managing director and head of the municipal bonds group at BlackRock, said at a roundtable discussion with reporters on Tuesday. While interest rate increases by the Federal Reserve are "clearly more in play than they've been in quite some time," tax reform issues could drive the market, he said.
"We are going to see a lot of choppiness in 2017, so I think investors have to be ready for that volatility, which will be caused by two things," he said: the uncertainty surrounding whether tax rates will be lowered or capped, which would diminish the value of tax exemption, or whether the tax exemption will be eliminated.
"Then there is the impact on the corporate side, which not only impact corporate buyers like property and casualty companies but banks and how they commit balance sheets to provide liquidity for the market," Hayes said.
"So some of that may have some unintended consequences for increased volatility in the market, as banks pull back a bit as it's not as advantageous for them to own munis on their balance sheet," said Hayes. "So the tax policy overhang will be there for some quiet time.
Sean Carney, director and head of municipal strategy at BlackRock, said it now appears tax reform will be pushed back into late 2017, early 2018.
"The one thing about fixed income in scenarios like this is that often when markets adjust, they initially overshoot only to then settle back to where they find fair value to be, so its going to be something to watch," said Carney. "If the top marginal tax rate is brought down from 39.6% to 33%, then the market can handle that – it's been done in the past."
The municipal market survived in 1986, when the top tax rate was cut to 28% from 50% and in the early 2000's, under President Bush, when it was lowered to 35% from 39.6%, Carney said.
Hayes said that BlackRock assigns a very low probability that the tax exemption goes away completely, mainly because there is growing awareness on the part of both Democrats and Republicans in Washington about the importance of the muni market for infrastructure.
The BlackRock muni team estimated that a drop in top tax rate from 43.4% to 33% would reduce $4,340 in annual savings to $3,300. They said any market correction to overcome a drop in the highest tax rate from 43.4% to 33% or even a 28% cap on the tax exemption would be manageable, potentially requiring yield increases of about 15 basis points for shorter maturities to 50 basis points on long maturities to compensate for the reduced tax benefit.
The BlackRock officials said pension funding concerns would continue to plague the market.
"Everyone seems to agree that pensions are a big problem, but no one has seemed to agree on how to solve it," said Hayes. "Until we see some resolution, it's like to continue to create downward rating pressure on a lot of those entities. You have to be careful navigating the market, particularly on the general obligation side. I would say that the credit spectrum has gotten more difficult, not less difficult, despite perhaps less headlines the past six to nine months. "
