The newly proposed and already underway tax proposition of the Trump administration, also known as the Tax Cuts and Jobs Act, has many investors scrambling for answers on the potential impact on their investment holdings.
In earlier discussions, the Trump administration was keen on reducing the marginal tax rate for the high earner. Given the correlation between municipal yield and income tax brackets, investors became increasingly skeptical of these changes and the reformation of the American tax codes. Thus, right after the election, municipal markets plunged with huge outflows out of tax-free debt and into equities or taxable fixed income securities. In addition, although the proposed tax change highlights significant changes to the tax-exempt space of the fixed income marketplace, it doesn’t address any of his campaign trail promises on revamping America’s ‘broken’ infrastructure.
In this article, we will take a closer look at the proposed changes to the current tax code and how that might impact the municipal debt markets.
1. Potential Impact on Private Activity Bonds
In state and local governments, municipal debt covers a wide array of financing tools for funding various projects. Private activity bonds (PABs) are one of those tools, and can be used by single or multiple private entities in conjunction with local or state governments to fund various projects. PABs are essentially a sub-segment of the broad muni universe.
The new tax plan proposal would repeal an eligible authority to issue PABs by the end of this year. In recent years, private sector involvement in meeting infrastructure needs has been drastically high for local and state governments, which had made PABs an essential part of the public-private partnership (PPP) ecosystem. PPPs have been playing a crucial role in the development of sectors like water and wastewater projects, housing (local- and state-level affordable housing, senior and military), transportation, government buildings, education, healthcare and energy (including production and distribution of energy, even renewable energy projects).
PABs aren’t used only for bigger infrastructure projects, such as construction of bridges or airports, but are also used for meeting the local needs of affordable housing, apartment complexes, etc. for local governments. As PAB provisions are projected to be phased out with this new tax plan, this might serve a severe blow to infrastructure projects for affordable housing.
Along the same lines, PABs will potentially lose their tax-exempt status under the new tax plan, which means that investors looking for tax breaks on their PAB holdings will no longer attain that benefit. This is critical for any PPPs and their fate going forward. GOP had ‘Crumbling American Infrastructure’ as its main tagline during the election; however, the new tax provisions will jeopardize PABs that are currently being used as the main funding source for many local infrastructure projects.
Check here to see what PABs are and whether they are suitable for your investment needs.
2. Potential Repealing of Advanced Refunding Provision
The new tax code has proposed to eliminate the advanced refunding provision in the municipal debt arena. Many local and state governments have often taken advantage of the advanced refunding on their debt due to the low interest rate environment and retired their existing bonds at a future date. The advanced refunding bonds are debt instruments often issued more than 90 days prior to the retirement of the old bonds.
Given the low interest rate environment, this provision will adversely impact local and state governments on their debt portfolios that are issued at higher rates, but not eligible for a call provision. In addition, as interest rates start to rise, it will make bond refunding less lucrative for local and state governments.
As a result, investors would have fewer refunding muni bonds to grab.
Keep our glossary of municipal bond terminologies handy to familiarize with different concepts commonly used by municipal investors.
3. Future of Professional Sports Stadiums
Federal tax expenditures that support the construction of a sporting infrastructure have been in use for many decades. The use of tax-exempt municipal debt for the construction of sporting facilities has been a very common practice among many government entities. This not only creates a revenue loss scenario for the federal government, it has been proven to not add any substantial economic growth for local and state governments. The commonly held belief among many politicians (who often decide on government subsidies for these infrastructures) and their constituents is that big sporting infrastructure construction has a substantial positive impact on local economies.
Under the new tax plan, local and state governments would no longer be able to issue tax-exempt debt for the financing of professional sports stadiums. This can be seen as a positive change and will stop the revenue loss for the federal government. For investors, it would mean seeking another investment vehicle to ensure their regular income or seek alternate means to get a boost in yield that would have otherwise been provided by some of the riskier bonds funding stadium projects.
Check here to know more about why sports stadium financing requires extra due diligence from investors.
The Bottom Line
As many of the proposed changes to the American Tax Code can have severe impacts on the municipal debt issuers, they are also bound to affect your fixed-income investment portfolios. The issuers and their debt issued prior to these changes will be grandfathered in and can still enjoy the same tax-exempt status. These changes are forward-looking and will impact any transaction that will take place after the effective date.
Investors must consult with their financial advisors and tax consultants on their holding and it’s important to understand the tax status of any fixed income instrument that you buy in the future, as it might have changed.
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