One of the most appealing attributes of municipal securities is their tax-exempt status on the income generated through their coupon payments. Besides being exempted from federal taxes, muni investors can also be exempted from state level taxes if they happen to reside within those states. In addition, muni bonds tend to attract investors with higher tax brackets as they realize the highest degree of tax savings.
Given the correlation between municipal yield and income tax brackets, investors became increasingly skeptical of the new administration and its campaign promises on reforming American tax codes. Thus, right after the elections, municipal markets plunged with huge outflows out of the tax-free debt and into equities or taxable fixed income securities.
In this article, we will take a closer look at potential uncertainties in municipal debt markets and how Trump’s policies around trade deals, income tax and infrastructure projects might impact the returns and decision making of investors with municipal debt in their investment portfolios.
What to Make of Trump’s Reforms in the Current Political Context
New administrations had made a wide array of campaign promises that had a significant negative impact on municipal markets post-elections. These reforms and propositions included tax reform, increased infrastructure spending, healthcare reform and reduction in federal aid to sanctuary cities, among others. Investors and fund managers were mainly concerned with reduction of the tax-equivalent yield due to potentially lower tax rates, leaving muni investors with fewer tax benefits.
Impact of Potential Tax Reforms
President Trump’s new tax reform entails reducing the tax rates for different incomes and reducing the tax brackets to only three. If we compare the proposed tax rates to the old marginal tax rates, it can be seen that benefits enjoyed by individuals on the highest tax bracket would reduce. These new proposed tax rates will certainly decrease the tax benefit for high earners, but since there isn’t much change in lower or middle tax brackets, the tax benefit on municipal debt will likely be the same. Although the tax reform and other policies may be enacted by the end of this year, the municipal yields on state and local bonds have trended downward in recent times. One of the reasons can be the lower correlation between local/state-level muni bonds with broader capital markets. Hence, the impact of the tax reform is likely to remain minimal. The historical trend also supports this.
Want to know more about the potential impact of Trump’s originally proposed tax reforms on your muni bond portfolio? Check out this article.
Push for Infrastructure
Presidential election promises also entailed an infrastructure boost that will not only create American jobs, but also boost private sector involvement into public infrastructure projects.
Since, in state and local governments, municipal debt covers a wide array of financing tools for funding various projects, private activity bonds (PABs) in the municipal debt arena can be used by single or multiple private entities in conjunction with local or state governments. PABs provide investors with the opportunity to cash in as political focus shifts to creating jobs through building and revamping the national infrastructure. The new government’s policy outlook hints toward an infrastructure push for essential utilities, i.e., schools, affordable housing, transportation, water and wastewater. For instance, consider the private partnership from the transportation sector in Denver, Colorado. The formation of a PPP between the Regional Transportation District and Denver Trans Partners (a private entity) led to the successful issuance of PABs, totaling $396 million for a rail lines expansion project (CUSIP: 759136QT4).
Click here to find out how to invest in the infrastructure segment in the US under Trump.
The Possibility of Repealing Obamacare
President Trump had highlighted the urgency of repealing the Affordable Care Act (ACA) aka Obamacare – an idea that struck a chord with virtually all the Republican Party. Although the efforts of repealing ACA are already underway, there is no clear plan or guidelines to replace the healthcare policies with something ‘better,’ as promised. The recent dilemma between Democrats and Republicans is ongoing on the newly proposed health bill by the Republicans, and the Senate is likely to take a final call on whether to repeal ACA or not before July 4.
ACA predominantly benefited millions of uninsured Americans and provided low-cost, discounted drugs to hospitals. The newly inducted health insurers, under the provisions of ACA, became paying members into the healthcare system and created new revenue streams for many hospitals, especially smaller hospitals in rural areas.
What is worrisome is that these hospitals have operated with very tight budgets. A repealment of the ACA would mean that these hospitals would lose the ‘currently insured’ individuals. As a result, revenue streams would dry up, leading to debt repayment issues. Consider the case of Fulton County in Georgia where $198 million of revenue bonds (CUSIP 3599008G5) were issued by the hospital and developing authorities. These revenue bonds can be severely impacted by the lower number of insurers due to no mandates for individual health coverage.
Quantum of Federal Aid to Sanctuary Cities
As most investors know, sanctuary cities are mainly jurisdictions where local law enforcement cooperation with the federal immigration officer is limited while providing details about illegal immigrant. President Trump had also promised to cut federal funding for these cities.
However, the impact is likely to be minimal. Much of the federal funding, for any given U.S. city, is mandated by the laws passed by Congress. Most of these mandatory federal level funding is directed toward essential services such as transportation, housing (HUD funding), health and safety. These revenue streams cannot be taken by a unilateral decision of the President and will not be affected by executive order.
Click here to find more details about the potential impact of Trump’s policies on sanctuary cities.
Key Considerations for Investors
As discussed above, some new administration policies are bound to have a bigger impact on municipal debt markets than others. Here are a few considerations for investors to better prepare for the future.
- Portfolio duration adjustment: There is a greater imperative need to perform a thorough duration analysis on any given investment portfolio than ever before. Investors should consider decreasing the average duration of their fixed-income portfolio, since securities with longer duration are more exposed to interest rate risk and tax-exemption changes.
- Consideration for taxable munis: Given the potential tax reforms, investors can also consider increasing their exposure to taxable muni bonds in due course of time. However, this depends on your tax bracket.
- Consideration for PABs: With an increasing scope of Private Public Partnerships (PPPs), investors must consider investing in PABs, especially in the utilities (water and wastewater) infrastructure space.
- Cautious approach to healthcare bonds: Healthcare investors should weigh their options and carefully analyze the impact of dismantling the ACA. This can be detrimental to smaller hospitals and their municipal debt.
The Bottom Line
Investors mustn’t get caught up in the monthly volatility of municipal debt markets and yields, but carefully examine the impact of new policies on their own fixed-income portfolios. There are some sectors that are likely to flourish under the new policies and there are some that might pose some serious threat to your investments.
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