Taxable boom may undermine the case for the muni tax exemption
There is a small but growing concern among some municipal market participants that the increasing popularity of taxable muni bonds could begin to undermine the community’s traditional argument to protect the tax exemption.
The proliferation of taxable muni deals this year is the result of a combination of factors, most prominently the loss of tax-exempt advance refundings in the 2017 Tax Cuts and Jobs Act and a low interest rate environment that has narrowed the spread between tax-exempt and taxable bonds. Analysts, lawyers, and lobbyists remain dedicated to the preservation of the tax exemption, but some said that an extended continuation of these conditions could make that struggle harder.
"Our number one concern in the advocacy arena is maintaining the tax exemption," said Brett Bolton, vice president at Bond Dealers of America.
Bolton said for issuers to have more options in the market is positive, which is why BDA continues to advocate for the reinstatement of tax-exempt advance refundings. But he added that BDA members had expressed concern that if the ability to tax-exempt advance refund does not return and more and more issuers turn to taxable deals in the meantime, it could start to be a threat.
"Going forward, it could definitely become a problem," Bolton said.
Through the end of October, $46.2 billion of taxable munis had been sold, representing 14% of total issuance. That was both the highest par amount of taxable debt issued and the largest market share of taxable muni issuance since direct-pay Build America Bonds inflated the statistics in 2009 and 2010. If BABs are eliminated from the taxable total and market share in those years, the 2019 figures are the highest on record.
Another $11 billion of taxable issuance came in November.
“Tax-exempt municipal bonds have been and continue to be the cornerstone of American infrastructure finance,” said Securities Industry and Financial Markets Association President and CEO Kenneth E. Bentsen Jr. “State and local issuers have periodically pursued taxable transactions when Congress has encroached on their ability to issue federally tax-exempt bonds. While the current low interest rate environment makes taxable issuance potentially economical, including for advance refunding of higher-coupon tax-exempt debt, it is a mathematical fact that taxable issuance is more expensive both in terms of coupon and escrow cost.
“Tax-exempt bonds are also a more economical option for state and local governments as municipal issuers of all sizes have access to a large and deep investor base comfortable with municipal credits and long-dated fixed-rate offerings,” Bentsen said. “Moreover, unlike most taxable bonds, tax-exempt bonds typically contain call provisions which afford state and local governments much greater future flexibility.”
One of the concerns that some in the market have is whether lawmakers and those advising them will fully appreciate the market dynamics that are driving this apparent reduced reliance on tax-exempt issuance. In the past, the Joint Committee on Taxation, a joint committee of Congress tasked with investigating the effects of taxes, has cast a skeptical eye at the muni exemption.
In a 2012 report met with some hostility by the market, JCT opined that “the tax-exempt bond subsidy is generally considered to be inefficient because, in most cases, the cost in terms of forgone tax revenues exceeds the value of the subsidy to state and local governmental issuers.”
“One of the takeaways for the industry is that this adds to the nuance of the municipal bond market,” said Patrick Luby, senior municipal strategist at CreditSights. “Market dynamics is adding a large new wrinkle. If you work at the Joint Tax Committee, that nuance might not be apparent to you.”
Luby said that the ability to effectively use the taxable market is mostly limited to large, regular issuers, and emphasized that most issuers continue to rely on the tax-exempt market even though some large deals have gone taxable.
“It’s very smart for large, regular issuers to want to have another tool in their toolkit,” Luby said. “An issuer should seek a diversified investor base.”
Taxable munis generally appeal to a different base of investors than the traditional muni buyer, which generally is limited only to investors who pay U.S. taxes. Taxable muni bonds appeal to international investors, who are attracted to the strength of U.S. municipal debt. The cities of Dallas and Fort Worth, Texas, for example, earlier this year opted to issue an entire $1.2 billion DFW airport refunding as taxable debt directly marketed to international investors. The sale netted international orders equal to 40% of the par offering.
More recently, California sold $1.1 billion of taxable GO bonds, riding a recent upgrade to a true interest cost of 2.40%.
“The headlines for the muni market are always the big deals, the blockbuster deals,” Luby said. “For local school boards and everybody else, it’s extremely important to have that tax exemption.”
Emily Brock, director of the Government Finance Officers Association’s Federal Liaison Center, drew a hard line about any change in perception brought about by the taxable trend.
“There’s no doubt that we are at a unique point in time — interest rates are at a significant low and issuers unable to advance refund tax-exempt municipal bonds due to the 2017 Tax Cuts and Jobs Act,” Brock said.
“Our champions have very candidly discussed the importance of the tax exemption as a cornerstone to providing infrastructure,” Brock continued. “They also understand and provide policy solutions that address the importance of ensuring issuers have choice — because they fully understand that state and local governments provide over three-quarters of the cost of infrastructure across the country. Many of our champions have seen a thing or two and understand the strength of the tax-exempt bond.”
Dee Wisor, a bond attorney at Butler Snow in Denver and the immediate past president of the National Association of Bond Lawyers, said he views the taxable explosion as the direct result of the TCJA and the low interest rate environment and said the market will not lose sight of the importance of the tax exemption.
“If tax-exempt advance refundings were still available, I imagine issuers and conduit borrowers would still be doing tax-exempt advance refundings and the volume of taxable deals would be substantially lower,” Wisor said.
“As the spread between taxable and tax-exempt rates returns to historically normal levels, the tax-exemption will remain important for issuers and conduit borrowers in managing their debt portfolio, in part because in normal market conditions taxable rates may not allow issuers to achieve the required level of savings in an advance refunding. So NABL, and I imagine others, will continue advocating for the preservation of the tax exemption generally and the restoration of tax-exempt advance refundings specifically.”
Wisor said he currently has one client doing two different refundings at the same time; one as a taxable advance refunding, while the other as a forward-delivery tax-exempt current refunding.
“The difference between the two is really just a math exercise and the municipal advisor advised the client to do the refundings in this way to achieve the issuer’s goals,” Wisor said.
Market participants have generally said they do not see a strong threat to the tax exemption while the U.S. House is controlled by Democrats, particularly so long as the tax-writing Ways and Means Committee is chaired by Massachusetts Democrat Richard Neal. Rep. Neal is a former mayor of Springfield, Massachusetts, and considered friendly to the muni market.
But there is no guarantee that the status quo will remain for long, with every member of the House up for reelection every two years and the complexity of partisan tax negotiations generally requiring all revenue measures to be on the table.
House Municipal Finance Caucus Chairmen Dutch Ruppersberger, D-Md., and Steve Stivers, R-Ohio, have introduced legislation to reinstate tax-exempt advance refunding that is awaiting action by the Ways and Means Committee. It has 22 cosponsors, including six Republicans.