How investors would adjust under the GOP House tax reform proposal
Municipal investors said the House GOP tax reform bill may create some opportunities, even as it slashes issuance of bonds and raises credit risk.
The Tax Cuts and Jobs Act (HR1), approved by the House Ways and Means Committee Thursday, would eliminate tax-exempt advance refundings, private activity bonds [PABs] for housing, private universities, not-for-profit hospitals, certain airports, ports, toll-roads, stadiums, and industrial development, as well as tax credit bonds, and alternative minimum tax paper.
The Senate Republicans’ tax reform proposal, based on an outline released late Thursday, would preserve private activity bonds and even enhance them, while advance refundings would still be terminated after this year.
"The biggest change in the Senate version is the ability of non- for- profits like hospitals to continue to issue tax-exempt bonds and other private activity type entities such as airports and toll roads to also issue tax-exempt debt to finance those type of projects," said Dan Heckman, senior fixed income strategist Minneapolis-based U.S. Bank. "This makes sense from the standpoint of emphasizing Infrastructure projects in the US. Both the House and Senate versions however do eliminate advance refunding’s, reducing billions of dollars in additional bonds that would come to the market, consequently denying governments the ability to refinance existing tax-exempt debt."
“The most concerning aspect for investors should be the expected decline in municipal bond issuance moving forward as we see the stadium bond proposal as highly likely of becoming law,” Michael Pietronico, chief investment officer at Miller Tabak Asset Management, said regarding the House GOP's bill last week.
“This potential decline in issuance tells us investors are too underweight in duration and as such should look to add both cash and duration to their existing municipal bond portfolios,” Pietronico said.
“If passed in its current form, the proposal would create a supply nightmare and lead to a wide range of credit issues for the public finance sector,” Triet Nguyen, head of public finance credit at New Oak Fundamental Credit, in a weekly municipal report on Nov. 3.
He noted that state and local governments would lose a tool for reducing their debt service costs if the elimination of advance refunding issuance is approved. As a result, “there might be a tendency to reduce the call protection period for investors, which will only add to the negative convexity already associated with municipal bonds,” Nguyen wrote.
Speculation that a proposed reduction to 20% from 35% in the top corporate income tax will create less institutional demand for municipals will be offset by the reality that “the municipal market is dominated by retail investors,” Heckman said. “Demand from individuals outweighs demand from institutions.”
That could all change if the House version of tax reform becomes law, according to a Nov. 6 report by Peter Block, managing director of credit strategy at Ramirez & Co. Block.
He said the bill's passage probably would transform the municipal market from a largely retail market into a more institutional market. He estimates that under the existing bill’s proposal, gross tax-exempt new issue supply likely would decline by between 30% and 40% and only be partially replaced by taxable bond supply.
“Taxable supply would be structured to appeal more to institutional investors rather than retail investors with par coupons, make-whole calls, and shorter durations,” he said. “The plunge in exempt supply would make tax-exempts the last remaining legal tax shelter available to individual investors -- even if individual rates remain 39.6% at the top bracket and/or corporate rates are 20%.”
Although the general exemption for municipals remains, “we can’t help but think that the GOP’s mission was to dilute the exemption as much as possible,” Jeffrey Lipton, head of municipal research and strategy and fixed income research at Oppenheimer Inc., wrote in a Nov. 6 report.
Heckman estimated that the elimination of private activity bonds would remove between $12 billion and $25 billion in issuance from the municipal market annually.
“Although it’s not a gigantic slice of the overall muni market, it is incremental,” he said, adding that PAB issuance is nearing pre-recession levels, after doubling in 2016 from 2015.
Over the past three years, tax-exempt advance refunding bonds and PABs together accounted for an average of 40% of gross municipal market supply, according to Block.
“The potential elimination of tax-exempts for this purpose is alarming for the market,” he wrote.
Meanwhile, the imbalance of supply and demand in the municipal market may worsen if the tax reform gains approval, buyside experts said.
“If these tax changes become law, the supply/demand chasm will widen further -- assuming tax reform does not appreciably undermine demand for the municipal asset class,” Lipton said in his report.
There is a strong argument to buy tax-exempt bonds in light of the proposed tax reform – and its impact on volume going forward, Nat Singer, senior managing director at Swap Financial Group, told The Bond Buyer.
Pietronico agreed, saying, “some tax deductions will be done away with and as insurance against that we urge investors to stock up on the municipal bond exemption as it may be harder and more expensive to find in the coming years.”
Singer said a tax reform-induced supply slump will be exacerbated by the already expected lack of current refundings in 2018 and 2019, as volume in 2008 and 2009 was dominated by Build America Bonds -- most of which had make-whole calls rather than standard 10-year calls.
“As a result, there will be less bonds in the market to current refund in the next two years,” Singer said in an interview. Combined, the dearth in issuance of advanced and current refundings will make it harder for investors who remain in the 39.6% top tax bracket to find adequate tax exemption for their growing income, he said.
That, Singer said, “could crowd more high net-worth investors into the tax-exempt market.”
“Less supply and more demand creates a scenario where muni bonds may become very rich,” and lead to declining ratios, Singer said.
Heckman agreed, saying that the likelihood of the top tax bracket remaining at 39.6% -- on top of a 3.8% Medicare surtax -- “enhances the need for tax-exempt paper more than ever” ahead of the potential for a significant drop in volume if the House tax reform bill passes in its current form.
“When a high-income individual is looking for ways to minimize their income taxes, tax-exempt munis are one of the few options,” Heckman said. “It becomes even more so the case if these measures pass.”
Heckman said the supply crunch for investors would be compounded by the elimination of tax-exempt issuance by 501 (c) 3 non-profit organizations like hospitals, higher education facilities, and nursing homes.
These entities have significant capital needs often financed by municipal bonds. “If that provision passes we will see more taxable municipal issuance,” Heckman said.
Still, some analysts said some of the bond reforms could lead to increases in price, value, and demand – and other technical factors - if the House version of the bill passes.
“Muni bond buyers hit a triple with this news and could fare very well in this proposal,” Michael J. Belsky, senior portfolio management director of Morgan Stanley Wealth Management’s Vector Group, told The Bond Buyer on Nov. 7.
“Although issuance might spike to take advantage of any changes in the law, I expect a marked decrease in supply, which should keep prices buoyant,” he said. “I don't expect an increase in rates as I did previously. Any decrease in corporate tax rates that would force rates higher is mitigated by the tighter supply.”
Lipton said there is potential scarcity value by eliminating certain types of financings, which can produce tighter spreads within these sector categories.
Heckman said the increase of taxable issuance by 501 [c] 3 entities under the new House bond reforms could turn into a positive for investors since the void “will increase the value of current tax-exempt bonds and any future issuance of tax-exempt bonds.”
Both the elimination of PABs and tax-exempt issuance by 501 [c] 3 entities “could add to the appeal and attraction of existing and any future issuance of tax-exempt bonds,” Heckman added.
“Should this financing vehicle be spared the ax, it may actually benefit from the spillover demand for yieldy instruments,” Nguyen said of the proposed elimination of tax exempt issuance by the non-profits.
The supply curtailment could also benefit all outstanding traditional high yield municipals, according to Nguyen, but he said, the investment grade portion of the market may not fare as well – particularly from a credit standpoint.
“The potential repeal of the AMT should lead to outperformance by bonds subject to the AMT, as the yield on those bonds would converge toward pure tax-exempt yield levels,” he explained. In addition, “the proposed elimination of PABs and stadium bonds should boost the scarcity value of yieldy paper.”
Buyside analysts said they were surprised to see the proposed elimination of new PAB issuance after it was previously considered the solution to a $1 trillion investment in infrastructure via public-private partnerships, but were not surprised by the elimination of tax-exempt stadium-bond financings.
“The [Trump] administration was pushing public-private partnerships as a way of achieving maximum operating results,” Belsky said.
Nguyen pointed out that “after months of debates about an expansion of the PAB sector as a potential solution to America’s infrastructure problem, drafters of the tax proposal ended up going in the opposite direction.”
“Market participants were completely blindsided by the proposed elimination of tax exemption for advance refundings and for private activity bonds,” Nguyen said.
“Proponents of tax-exempt financing were bracing themselves for a potential hit on the marginal demand for municipals, primarily from a tax rate reduction for corporate buyers such as the banks,” he wrote. “What they got instead was a wholesale assault on the supply side of the equation.”
As a percentage of total supply, advance refundings have been on a decline, according to Nguyen, as public issuers have largely exhausted refinancing opportunities in the low rate environment. But, he pointed out, “any further reduction in supply will only exacerbate the already tight technicals in our market.”
There are also disadvantages for the sell-side, the experts noted.
Lipton said the loss of both PABs and AMT-subject bonds could create a dramatic shift in the technical landscape of the municipal market and issuers would find themselves “economically penalized with significantly scaled back access to the tax-exempt market.”
“The proposed elimination of state and local income and sales tax deductions may severely limit the revenue-raising flexibility for high income tax states,” Nguyen noted, even though the same may enhance the tax shelter appeal from those states.
This elimination could elevate demand for in-state municipal bonds in high taxed states, Lipton added.
“It’s a bad day for issuers, as the plan restricts pre-refunding, puts limitations on non-profit hospitals and universities, and a reduction of exemptions for property and casualty companies,” Belsky of Morgan Stanley said of the House plan.
“States and locals will have to tighten budget belts again, as they don't enjoy the same flexibility, especially with pre-refunding restrictions,” he said, Belsky said he continues to prefer essential service revenue bonds for his high net worth individual investor clientele.