For both individual and corporate investors, your tax rate serves as one of the biggest alluring or deterring factors in buying any municipal debt instruments. Typically, the interest earnings from municipal debt is tax exempt, safeguarding your total interest income from your marginal or corporate tax rate.
However, recent Securities and Exchange Commission filings by some of the major U.S. banks showed them reducing their state and local government bond holding by billions of dollars. For instance, Bank of America, JPMorgan Chase and Wells Fargo collectively reduced their local and state government holdings by close to $8 billion dollars during the first three months of 2018 and many other small and mid-size banks are following suit.
In this article, we will take a closer look at the steady increase in municipal debt demand after the economic collapse of 2008, the factors leading to significant reduction in muni debt exposure by major banks and what the future holds for the demand of municipal debt instruments.
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Municipal Debt Demand for Banks
In the last decade, U.S. chartered depository institutions and banks showed the big increases in their municipal bond holdings. This increase was primarily due to the tax rules associated with the 2009 American Recovery and Reinvestment Act, allowing banks to deduct 80 percent of the interest costs on tax-exempt bonds issued in 2009 and 2010.
From the chart below, a steady upward trend in municipal debt demand for the banks can be seen, with the collective holdings ballooning from $191 billion in 2006 to $537 billion in 2016. The tax exemption on the interest income from municipal debt securities made sense to banks, given their corporate tax rate of 35%.
Corporate Tax Rate and Municipal Debt
On one side, the new tax reform earlier this year was seen as one of the most transformative measures to sustain economic growth and create more jobs by lowering the corporate tax rate from 35% to 21%; however, it served a significant blow to the municipal debt markets and lowered the favorability of municipal debt as an investment instruments for bigger institutional investors such as banks and insurance companies.
For example, if a municipal debt investor currently in a 35% tax bracket earns $100 tax-free interest on his muni investment instrument, then his total tax savings is $35; however, when the tax bracket is lowered to 21%, the same tax benefit decreases to $21 and municipal debt becomes less favorable compared to other taxable investment instruments offering high yields to compensate for the tax benefit and more. The new corporate tax rate has certainly decreased the tax benefit for corporations. The potential lower demand for municipal debt from institutional investors like banks will put an upward pressure on municipal debt yields to compete with similar investments.
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Furthermore, the rising interest rate environment has had a negative impact on municipal debt holdings, which hasn’t helped the case. The federal government has hinted towards more interest rate hikes, which could further lower demand and potentially cause even more sell-offs by institutional clients.
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Can the Newly Signed Legislation Reverse this Trend?
On May 24, 2018, President Trump signed legislation aimed at loosening the Dodd-Frank regulations on banks and financial institutions. As part of this signed legislation, certain investment-grade municipal bonds can be included in the HQLA (High-Quality Liquid Asset) category.
Every financial institution in the United States is required to maintain the Liquidity Coverage Ratio (LCR), which means that banks must maintain a minimum level of liquidity to help ensure access to sufficient funds during the event of financial stress, etc. Financial institutions meet this requirement by holding High-Quality Liquid Assets (HQLA). Prior to the recently signed legislation, these assets included cash and other low-risk instruments, but not municipal bonds. However, the recent legislation has included municipal debt into the HQLA (High-Quality Liquid Assets) category, which is likely to offset some of the negative impacts and limit the decline in demand for municipal securities arising from tax reform.
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Potential Impact on the Municipal Debt Markets and Issuers
As banks and other institutions continue to lower their municipal debt holdings, the municipal capital markets will see a widening gap between supply and demand of municipal debt, potentially putting downward pressure on the debt pricing. The reduced demand for these instruments also has the potential of driving up the borrowing costs for state and local governments. This trend of unloading your municipal debt reserves isn’t limited to just banks but can potentially spread to property and casualty insurance companies later this year. These banks and insurance companies are likely to invest in other investment vehicles with comparable credit qualities but better returns than municipal debt instruments. The tax-free returns may not be their biggest selling point at this time.
As mentioned above, the first-quarter reports of a significant decline in municipal debt holdings by financial institutions can be reversed by the newly signed legislation, under which municipal bonds are now considered HQLAs for financial institutions and can help fund their reserve requirements.
Potential Impact on Individual and Retail Muni Debt Holders
As banks and other financial institutions are reducing their local government debt holdings, individual investors can potentially capitalize and gain from the lowered corporate demand for municipal debt, as this is likely to push the yields higher.
The supply and demand of any security (especially municipal debt) has a direct correlation with the pricing of these securities. For instance, when demand is high, municipal issuers can access the markets more easily and can issue debt at more favorable terms.
On the other hand, when the supply becomes abundant, access to the municipal capital market typically becomes favorable for investors, because there isn’t much demand; this seems to be the case in the current environment, where the bigger players seem to be buying less. However, this situation could potentially be worrisome for issuers looking to access the municipal debt markets in the future, as it may be more expensive than before.
The Bottom Line
As many of the enacted changes to the U.S. tax code will have severe impacts on the municipal market, they are also bound to affect your fixed-income investment portfolios. Municipal bond holdings by financial institutions will continue to see a decline due to the change in the corporate tax rate; yet individuals will stand to gain from the lowered corporate demand for municipal bonds that is likely to push yields higher. Higher yields mean higher returns, as long as bonds are held to maturity. Since individual tax rates are essentially unchanged, individual investors will continue to have the same tax benefit from municipal bonds, but at higher yields.
Investors must consult with their financial advisors and tax consultants on their holdings, and it’s important to understand the tax status of any fixed-income instrument that you buy in the future, as it may have changed. Also, be sure to do your part of due diligence before investing in muni debt.
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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisors prior to making any investment decisions.