The newly introduced tax bill is going to have a substantial impact on the issuance of tax-exempt debt by local and state governments and on the municipal debt markets.
In earlier discussions, the Trump administration wanted to reduce the marginal tax rate for high earners. The new plan brought the corporate tax rate down from 35% to 21%, which is going to have an adverse impact on the demand for municipal debt as an investment instrument for corporations.
In this article, we will take a closer look at all the enacted changes with the tax plan and its impact on municipal debt markets, and if it will provide opportunities for retail muni investors to potentially earn higher yields.
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1. Retention of Private Activity Bonds (PABs): The beginning of tax-reform talks entailed abolishing the tax exemption for PABs and limiting/eliminating the Public Private Partnerships (PPP) where local governments and private entities would work in conjunction and access the municipal markets as a funding source. However, there has been an enormous outcry from local and state governments and private entities stating that eliminating the tax exemption on PABs would not only increase the cost of capital but would also be detrimental to infrastructure growth. For state and local governments, municipal debt is considered a financing tool to fund a wide array of projects. PABs are one of those tools and can be used by single or multiple private entities in conjunction with the local or state governments. PABs are essentially a sub-segment of the broad muni universe.
However, unlike general obligation debt, where a city’s credit worthiness and tax revenues provide the backing, PABs’ revenue streams come directly from the projects and are backed solely by the private entity’s credit rating. This poses an increased risk for potential investors, as PABs can be viewed as tax-exempt corporate bonds. Despite the similar maturities, the PAB offers a higher coupon to compensate for the risk factor attached to the private entity’s debt repayment capacity. In recent years, private sector involvement in meeting infrastructure needs has been drastically high for local and state governments. This makes 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).
Be sure to read our previous article on Potential impacts of Tax Reforms on Tax-exempt munis.
2. Elimination of Advanced Refunding Provision: Advanced refundings have been a lucrative avenue for local and state governments to refund their existing debt at lower coupons and capitalize on the low rate environment ahead of the bond maturity or call date. The new tax code eliminates the advanced refunding provision in the municipal debt arena.
Given the low interest rate environment, this provision will adversely impact debt portfolios of local and state governments that are issued at higher rates, but not eligible for a call provision. In addition, the elimination of advanced refundings will put downward pressure on supply, as issuers will no longer be able to issue advanced refunding bonds. This will partially offset the decreased demand from institutions that is likely to occur given the lower corporate tax rate.
Keep our glossary of municipal bond terminologies handy to familiarize with different concepts commonly used by municipal investors.
3. Reduction in Corporate Tax Rate: Another blow to municipal debt market comes from the lowering of the corporate tax rate from 35% to 21%.
This has been viewed as one of the most transformative measures in the corporate sector to sustain the economic growth and create more jobs, but it has lowered the favorability of municipal debt as an investment instruments for bigger institutional investors such as banks and insurance companies. For example, hypothetically, 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 the 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 will certainly decrease the tax benefit for corporations. The potential lower demand for municipal debt will have an upward pressure on the municipal debt yields to compete with similar investments.
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4. Allowing Tax-Exempt Debt to Fund Sports Arenas: The use of municipal debt (tax-free) for the construction of sporting facilities has been a common practice for many local and state governments. In the new proposition, it was recommended to eliminate the tax exemption on sports stadium financing that was not approved and stadium tax-exempt munis were eventually retained in the new tax laws.
The most common argument that’s often used to justify the construction of a sports facility and further subsidizing it with public funds is that building a facility will expand the local economy, generate more revenues, increase consumer spending, bring more jobs (both construction and operational jobs) and, furthermore, it’s assumed that wages created by these jobs will be re-spent into the local economy. From the local government’s perspective, building a new sporting facility will not only revitalize the surrounding areas but potentially promote tourism for the city. This assumption also entails the potential construction of more commercial and residential properties, thus, creating new revenue streams for the municipality.
However, these assumptions may not be entirely accurate or hold much weight because studies suggest that the money set aside for entertainment by an individual isn’t going to see much of an increase simply because there is a new entertainment option (e.g. new sports arena). The existing entertainment budget will simply shift to the newer option from the old entertainment options (local businesses, recreational activities, restaurants, etc). This refutes the argument that newly constructed sports arenas will only bring more business and potentially create jobs; it will also severely impact the old business and their revenue streams. Historically, the cities that have built these sporting facilities show that sporting event revenues typically constitute a small share of a city’s economic output and these events do not employ a substantial number of people.
This tells us that the overall positive impact of constructing a new sporting venue is very small to the local economy.
Key Consideration for Investors
- As a result of these changes, issuers will have to reconsider their positions and access to capital via municipal debt markets. It is important to note that high debt service on existing debts would be a good sign for investors, until they become eligible for refund.
- Given the corporate tax rate change, muni debt will be less attractive for corporate investors, which will potentially lower demand for muni debt in the market and push yields upward.
- While demand will be negatively impacted from an institutional point due to lower corporate tax rates, supply will also be reduced due to the elimination of advanced refunding bonds. This decrease in supply will partially offset the lowered demand, decreasing the upward pressure on yields.
Be sure to check this article to remain aware of the due diligence process for evaluating municipal bonds.
The Bottom Line
As many of the enacted changes to the American Tax Code will have severe impacts on the municipal market, they are also bound to affect your fixed-income investment portfolios. Individuals will stand to gain from the lowered corporate demand for munis that is likely to push yields higher. Higher yields mean higher returns, as long as bonds are held to expiration. Since individual tax rates were essentially unchanged, individual investors will continue to have the same tax-benefit from munis but at higher yields.
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 may have changed.
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