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The start to this year is the most complex and uncertain transition in the municipal bond market since the 1986 Tax Reform, due to four main factors:
The impact of the Tax Reform Law on the supply/demand structure of the market
The continuing move toward higher short-term rates
The potential for an infrastructure bill of uncertain size and scope, and other concerns about infrastructure
Likely continued erosion in average credit quality.
The Preservation of PABs was essential for a great deal of work to come on infrastructure. Now what?
The tax bill is, of course, law. We now will have to wait until later in the year to see what, if anything, can be moved through Congress to actually help support financing and funding of infrastructure. We stress again that the key issue is funding, not financing, and that help with funding would require substantial added resources from the Federal government, just after a large hole has been created in the Federal budget by tax cuts. While the annual effect of the tax cuts on the size of the deficit may decline over time, they will be the greatest in 2018-9, and are very likely to generate resistance, especially on the House side, to substantial additional spending on infrastructure.
For a look back on our infrastructure funding guidelines, click here. The initial annual deficits remain. Will there be willingness to add to the initial deficit coming out of the bill before evidence of this new revenue generating capacity shows up? We remain dubious.
Furthermore, the closing off of advanced refundings without even a transition period was deeply disappointing, and will in effect make a challenging environment post Tax law even more difficult. So we now begin to take a look at the implications of the new Tax law, given its major components that affect the muni market:
- 21% corporate tax rate,
- 37% maximum individual tax rate,
- A substantial cut in the tax rate on pass-throughs,
- Retention of capacity to issue nearly all PABs, but,
- The loss of the capacity for issuers to do advanced refundings.
Factors that will lead to dramatic changes in market demand:
- The fact that individual investors have not been direct buyers of munis to a substantial degree since at least 2008—in the aggregate, we estimate that since the end of 2010, when issuance of Build America Bonds ceased, direct retail holdings of tax-exempts are down roughly $550 billion, while holdings in Separately Managed Accounts (SMAs) are up roughly $250 billion and holdings by funds are up roughly $160 billion.
- The dramatically increased role over that period of Commercial Banks, whose holdings are up roughly $300 billion in publicly held paper, and some unknown additional amount in private placements.
- The new, sharply lower tax rate for banks, at a maximum of 21%.
- An even lower effective benefit of holding munis for Property and Casualty (P&C) Insurers, whose current holdings aggregate $342 billion—just slightly less than the $348 billion they held at the end of 2010.
Under current law, P&C insurance companies are required to reduce losses incurred by 15% of a) the company’s tax-exempt interest income, b) the deductible portion of dividends received, and c) the increase for the tax year in the cash value of life insurance, endowment, or annuity contracts that the company owns.
The effective tax rate on these amounts under current law is 5.25%, reducing the net benefit of holding tax-exempts to a tax rate equal to 29.75%. The Tax law increases the proration percentage to 25%, floating with any future changes in the statutory corporate tax rate, to maintain an effective tax rate of 5.25%—but against a 21% tax rate. The effective benefit of holding munis drops to a comparison with a 14.75% effective tax rate on taxable.
We note that the effect on pricing for any given asset results from marginal demand, not aggregate holdings. Yes, the household sector, after excluding SMAs, still holds about $1.21 trillion of munis—nearly all tax-exempt. However, that represents a massive roll-off relative to the $1.850 trillion or so the held at the peak. Every large proportion of those direct holding are quite short in maturity. There continues to be resistance from direct retail to moving further out along the curve, as yields remain low by historical standards and the Fed remains in a tightening mode.
On the institutional side, note that a key factor in terms of the impact on muni yields will be the extent to which they become net sellers. Clearly, the implications of the tax law for corporate demand for munis are quite negative, given: 1) the reduction in the maximum marginal tax rate on corporations from 35% to 21%; and, 2) the increase in the Property and Casualty Company “Haircut” from 15% to 25%. Some behavioral effects from these changes will be based upon relative yields versus corporates, and some will be based upon business decisions within the dealer function of municipal underwriters and traders.
For example, will banks, with their sharply lower tax rates and lower marginal demand for munis maintain the same role they had as a provider of liquidity in the secondary market? The answer isn’t clear, at least to us. We are not expecting insurers to abruptly sell all of the tax-exempt munis they own, but we expect them to go into roll-off mode, essentially only adding to holdings opportunistically when munis are cheap, and increasing roll-off when they are not.
Commercial banks, we anticipate, will add tax-exempts at a sharply lower pace than the roughly $42 billion per year they added during the period 2011-3rd quarter 2017. Indeed, during some periods, we would anticipate banks to be net sellers, and we would suspect that some holdings of directly purchased munis will be re-structured as public securities and sold off as well. At the very least, new purchases in private placement form are likely to dwindle.
What, then will the direct impact of all of these changes be?
A large number of factors are at play here, and we are only in the early stages of attempting to put them all together. Some will be based upon business decisions by corporations that are not yet obvious. While under the Tax law, PABs can still be issued, there will be a slow-down in PAB issuance after the substantial rush to market prior to mid-December, when there was a risk that new issues would be forbidden under the provision in the House version of the bill. We also note that because advanced refundings are prohibited under the new law, refunding volume will drop sharply until existing bonds reach the period 90-days before their first call date, when they become current refundings.
This will not cause refundings to disappear for very long, because roughly 70% of advance refundings have been done less than 2 years before the first call date in recent years, and most of these will come back as current refundings after a hiatus of 1 ½ years or so.
The new rules will cause a severe slowdown in the 20%- 30% or so in refundings that were done for reasons other than savings. We estimate that refundings could go from $145 billion in full-year 2017 to $50 billion or lower in 2018 under the new provisions, and then begin a slow glide back up—but probably not all the way to the $145 billion range.
The refundings that do get done will include current refundings that didn’t get done previously as advanced refundings, and some esoteric new structures designed to adhere to the new rules, such as municipal forwards that are sold ahead time, but are only formally issued when the 90-day pre-call window is reached, and possibly other new structures than may be introduced as technical fixes to the Tax law occur.
Technical Fixes and Other Changes
We are quite confident of the need for technical fixes, given the spectacular speed with which the Tax Bill was constructed, with practically no input from outside tax and accounting experts.
Such fixes could include, for example, closure of unintended loopholes that make the deficit larger than anticipated. Whether any such fixes will pave the way for changes that benefit state and local governments is uncertain—but, we fear, also unlikely. One exception that has been bounced around is permission for issuers to do advanced refundings that are escrowed in tax-exempts prior to the first call. This format would be more costly for issuers than prior advanced refundings, but not by all that much given the short time to the first call on most advanced refundings. And, since one tax-exempt would simply be replacing another, there is no net cost to the Treasury. Ultimately, we expect something like this to be enacted, which would significantly replenish the volume of advanced refundings.
Detailed Market Implications
Some of the key factors that will affect market patterns include:
- A very sharp decline in new-issue supply relative to the $445 billion done in 2016 and the $436 billion or so done in 2017. Total supply in 2018 could easily drop 25% to the $320 billion range, as issuers who rushed to market move to the sidelines, and refundings drop by close to $100 billion.
- Some resale of bonds originally sold in 2017 during the November/December rush to market.
- Very slow issuance during the first quarter of 2018.
- Ultimately, more use of complex structures to achieve needed refundings.
- In some cases, a move to a first call date shorter than 10 years, but with a significant yield penalty for doing so—the desire by investors either to get 10-year protection or get significant compensation for shorter calls isn’t going away.
- Sharply more market volatility and less liquidity as banks become a weaker and less consistent buyer of munis.
- Much greater challenges in placing longer-maturity bonds with lower coupons than the 5% level that the institutional market (including especially bond funds) desires. In recent years, the biggest buyers of below-5% coupons on larger issues have been banks.
- Specific maturities that become difficult to place in the absence of P&C demand and with weaker bank demand. It is important to note that SMAs mostly function inside 10 years, and muni funds tend to prefer mostly long paper, so that there will sometimes be a demand “hole” in the 10-17 year range that is difficult to fill except at yields very close to taxable yields.
- A potentially greater role in exchange-traded funds and electronic trading platforms in providing liquidity.
- Periods when it becomes extremely difficult for smaller issuers to sell longer serial maturities except at yields sharply higher than current “benchmark” yield levels.
- Ultimately a larger role for foreign investors and “crossover” buyers during the much more frequent periods when demand from traditional buyers of tax-exempts dwindles, and non-traditional buyers see an opportunity to accomplish a total return trade with total yields higher than they expect to accomplish in the taxable market;
- In many cases, narrower yield spreads between PABs subject to the AMT and other bonds that are not. Under the new law, fewer individual investors will be subject to the AMT, and the effect of the AMT on corporations has been eliminated.
- A somewhat bigger spread in yield between bonds issued in so-called high-tax “specialty state” and the general market. This will occur for two reasons: the cap on deductibility of state and local taxes, which will push up the net tax rate for many high-income individuals; and reduced demand from institutions that are less susceptible to state taxes.
- Still-uncertain implications of the cut in tax rates for pass-throughs. We suspect that for many pass-throughs, the effective tax rate on taxable investment income will still be at the investor’s individual tax rate, because income on the individual’s investment portfolio will be outside the pass-through. If this is the case, the benefit for high-tax-rate individuals would be preserved—we will need to see how this plays out.
The above only begins to describe the new complexities facing tax-exempt issuers in this “brave new world.” We will return to this topic as the Tax law is implemented this year, and thus as new patterns begin to show up. Nevertheless, we anticipate that higher yields relative to corporates, more volatility, less liquidity, and a greater role for crossover buyers is inevitable.
Other changes for 2018 and beyond:
Lots of the changes for 2018 and beyond are not yet obvious. In addition to the effects noted above, we continue to think consistently about a number of issues that are not fully related to the Tax law. These include:
- Continued erosion in aggregate credit quality;
- Continued erosion in the strength of support for state and local governments from the Federal government—an erosion in “Fiscal Federalism” that is unlikely to be reversed;
- Continued tightening of monetary policy by the Fed, which will likely lead to additional flattening of yield curves, but also potentially to higher long-term rates in the muni market specifically. More about this next week.
- A continued emphasis on responses to technological change, in ways that we will address further in an upcoming Perspective. For a review on our initial thoughts on technological change, click here.
And Many Other Changes—You Aren’t in Kansas Anymore
Toto says, “ruff,” or more accurately, “rough.” We are transitioning into a vastly different market environment, and market participants are going to get used to seeing flying monkeys a lot more frequently. Some of the potential changes are clear, and some will depend upon adaptations by municipal market participants. Some of these changes will occur slowly, as the market experiences a very light first quarter that permits participants to ease into new ideas and ways of functioning into the market over time. We caution academic participants that any study they do that does not incorporate a section that adjusts time series for the new Tax law is already obsolete.