This Market Commentary is part of Court Street Group's Perspective. For a full copy of the report, click here.
The muni market outperformed Treasuries over the past week. Or it underperformed. Or it remained constant. It was a mixed bag for munis this week with yields rising slightly. However, finding a consistent theme is difficult because there is so much noise in the data right now, that it’s difficult to tell where the market stands.
Why all of the noise? Because:
- We don’t yet know whether there will be a tax reform bill that passes the full Senate. The outlook for obtaining the needed 50 votes out of 52 Republicans is highly unclear, especially after one Senator already said “no” and the Federal Mandate for the ACA was thrown back into the debate, likely cutting as many as 13 million from the health insurance roles. In addition, questions about how the middle class fares under the House and Senate versions are likely to grow over the Thanksgiving recess. What will the Senate politics on the bill look like in nearly two weeks? Impossible to tell, in our view.
- We do know that any bill that does make it through the Senate is likely to eliminate new advanced refundings starting 1/1/18, but keep private activity bonds.
- We don’t know how PABs are going to fare if a bill makes it to Senate/House conference, but we are hopeful. We detail below why eliminating PABs in 2018 couldn’t come at a worse time for state and local governments and the muni market.
- That said, will issuers with deals nearly ready to go—refundings or PABs—attempt to get them done prior to a proposed 1/1/18 effective date?
- We suspect that some will, but it is difficult to tell how many. So, there could be a rush to market in December, but if both PABs and Refundings were to be eliminated, it might be followed by vastly lighter supply starting next year.
- And, of course, on both sides of Congress the AMT is likely to be eliminated, making outstanding PABs that are currently subject to the AMT worth more.
- Even if PABs are preserved, any rush to market in December would likely be followed by a light period in early 2018.
- So, at some price, probably with yields not too far above current levels, any extra supply is likely to be fully absorbed.
- Speaking of supply, with next week’s holiday-shortened week, it looks to be about $4.2 billion, led by New York City MTA’s $2 billion of transportation revenue refunding green bonds. The issuer increased the deal size from $600 million, further highlighting issuer concerns about tax reform effects.
- Lipper also reported fund inflows of $417 million after last week’s $463 million. There have been only 10 weeks this year when flows were negative.
Two last sets of thoughts, for now. First, on the proposed 20% corporate tax rate:
As we have discussed, gutting ability for state and local governments to issue a significant part of the current tax-exempt market, while also gutting deductibility of state and local taxes, beggars fiscal federalism.
This, in our view would be an unfortunate—and unnecessary—consequence of cutting the corporate tax rate all the way to 20%, far further than it needs to be cut to increase U.S. competitiveness with the rest of the world. Currently, the GDP-weighted average maximum corporate tax rate for OECD nations is around 29%, versus the U.S.’s 35%—although very few companies pay the full 35% on all of their income, or even close to it.
As recently as 3-4 months ago, very few observers, even on the Republican side, expected the corporate rate to be cut all the way to 20%. Most predictions were running 25%-26%. The drop down all the way to 20% appears to have been pushed hard by President Trump, and Congress caved. Congress then had to find revenues to make up the difference, and state and local governments were caught in the crosshairs, for no good policy reason.
We note an op-ed by Hugh Hewitt from the Washington Post that asserts an infrastructure bill is coming in 2018 -- Only there is no conceivable way that Congress will budget an extra plugged nickel for infrastructure, let alone an entire new program, right after creating a $1.5-1.7 trillion new 10-year hole in the Federal budget through tax reform. We just find this to be nearly impossible and truly a bait and switch move in the middle of the tax reform debate. And as noted above, tax reform already is hitting state and local governments the hardest, leaving what little funding for infrastructure they had even worse off. State and local government officials should hold their breath that this Congress will do any work to help fund infrastructure in 2018.
Second, on availability of new money to build infrastructure, as proposed earlier by the President: We also note that even before Tax Reform, the U.S. is a low-taxed country, a fact that doesn’t appear to be well known. According to OECD data, taxes as a percentage of GDP for the entire OECD in 2015 was 34%. The U.S. ranked near the bottom, at less than 27% of GDP, despite the noise generated by having multiple tax jurisdictions.
Why so low? Because corporations are already paying a disproportionately low amount, and because tax shelters and loopholes abound—virtually none of which are available to the bottom 90% of individual taxpayers. Meanwhile, the amount being spent at the Federal level on infrastructure is already low, and likely to go lower. We would argue strongly that, after creating a $1.5-$1.7 trillion new hole in the budget, appetite for spending anything more on infrastructure through the Federal budget will practically vanish.
Why Now is the Wrong Time to Eliminate the Tax Exemption for Private Activity Bonds
The House-passed tax reform bill beats up on the municipal bond market and state and local bond issuers to an extent never envisioned before.
There was at least some recognition that the administration had interest in bringing more private capital into public infrastructure via P3s and tax credits and that there was at least some recognition that the public sector and private sector participants would need to work together in the future to optimize funding that would be needed to keep state and local projects and activities from falling farther into disarray.
This recognition, it was believed, connected the effective functioning of the municipal bond market to the need to enhance economic growth by maintaining and expanding state and local projects, such as infrastructure, that create jobs and provide needed governmental services. There is, in the U.S. and globally, virtual unanimity among macroeconomists and development specialists that creation and maintenance of competitive infrastructure is essential to economic growth and competition. In the U.S., a key component of any such plan is the need for state and local project developers to have access to the lowest possible financing cost, through the use of tax-exempt financing, and in a wide range of sectors through the use of Private Activity Bonds as defined in the IRS code.
The House bill has shown market participants that the drafters of these documents had no interest in leaving the muni market alone, or in keeping the state and local component of the Federal “compact” intact to meet funding needs. We discussed a large number of the factors in the House bill that would increase funding costs or reduce access to low-cost financing, in a report on November 3. In a second piece on November 10, we focused specifically on [maintaining state and local access to advance refundings, which both initial House and Senate Tax Reform drafts would eliminate.
In this discussion, we focus specifically on the importance of maintaining access to private activity bonds, through a series of questions and answers.
Cuts this deep clearly leave a hole in the Federal budget that will be filled over time in ways that are damaging to recipients of disbursements from the Federal government. High on that list are state and local governments. Witness the likely impact of this proposal, which, in a bolt from the blue, seeks dramatic new revenues from the municipal sector to pay, in part for the massive tax cuts, and which will leave no room for the supposed previously planned, highly publicized “infrastructure program.”
We, unfortunately, are highly confident that no such program will be seriously considered in the aftermath of a Tax Reform plan that creates roughly a $1.5 trillion new 10-year deficit. Are lawmakers going to turn around soon after generating such a new deficit, and enact a plan that puts new funding behind infrastructure projects? In our view, such an outcome is inconceivable. And, of course, with this proposal, we are already seeing evidence as to the way deep new holes in the Federal budget would beggar state and local governments in a variety of ways. In our view, six such ways stand out:
The two provisions that would most directly cut access to low-cost tax-exempt financing: the elimination of advanced refundings, and the elimination of tax-exempt financing for Private Activity Bonds (PABs) which we focus on below;
The sharp reduction in marginal tax rates for corporations, now targeted at 20%;
A specific, deliberate reduction in the value of tax-exempt income for property and casualty and life insurance companies, in the form of increased insurance company “haircuts” which penalize insurance company holdings of tax-exempt bonds and, in effect further reduce the value of the tax-exemption for such companies. This would, of course, push up the break-even yield relative to corporates, at which munis would be competitive;
As noted above, much lower odds of any post-Tax Reform infrastructure plan which throws even an extra dime at state and local projects;
Now, a new provision that, if enacted, would put new holes in state and local budgets, and at the same time impair the budgets of a significant number of public and non-for-profit hospitals: the proposal to eliminate the healthcare mandate in the Affordable Care Act. Without the mandate, economists suggest, fewer healthy people would buy health insurance. Their exit from the market would raise insurance prices, driving out still more healthy people in a spiral of rising prices and lower rates of insurance coverage. And this, in turn, would put more pressure on healthcare providers, including states that help provide support for healthcare.
And finally, news from the CBO in a letter sent to Democratic Whip Steny Hoyer this week that suggests OMB will need to offset some of the $1.5 trillion deficit from the bill with sequestration from the PAYGO act of 2010, which would likely include Build America Bond and other taxable muni bond subsidies beginning in 2018. The fact that most outstanding BABs are longer-dated, this would make a big hit on issuers. Senate Finance Committee Chairman Orrin Hatch said that Congress has routinely exempted spending and revenue measures from the PAYGO scorecard since its enactment 7 years ago. However, there is no language in either the House bill, which passed Thursday, and the Senate bill, that specifically exempts PAYGO.
As we have noted before, one Congress cannot control what future congresses will legislate and nothing is ironclad, as evidenced by BABs subsidies subjected to sequestration over the past years. These Tax Reform proposals are the clearest evidence of that fact.
The Impact of the Elimination of PABs — Less Infrastructure at Sharply Higher Costs
As noted in our first piece on November 3, we think that it is essential to view all of the proposed changes that would impair the muni market in the context of a Federal system of government. If a given change increases revenues at the Federal level, but sharply increases borrowing costs at the state and local level, then in a Federal system, the aggregate increases in costs at the state and local level need to be netted out. After all, state and local governments are NOT “just another special interest;” they are partners with the Federal government in providing governmental projects and services.
Elimination of the ability to issue any private activity bonds on a tax-exempt basis after 2017 is a shockingly broad-based change to the municipal bond market. We do note that the Senate version of the legislation does not eliminate PABs, but does eliminate advanced refundings and the state and local tax deduction (SALT).
The House bill would eliminate access to tax-exempt financing for all hospitals, nonprofit colleges and universities, affordable and low-income housing bonds, qualified redevelopment bonds, airports, ports, solid waste disposal revenue bonds, wastewater treatment facilities that are defined as “private activity,” student loan revenue bonds, and a number of other activities.
In our view the rationale for this incredibly sweeping diminution in access to tax-exempt financing, as described in the documents supporting the changes, in particularly misleading and disingenuous. As noted,
“The federal government should not subsidize the borrowing costs of private businesses, allowing them to pay lower interest rates while competitors with similar creditworthiness but that are unable to avail themselves of PABs must pay a higher interest rate on the debt they issue.”
This statement is incredibly misleading and incorrect in a number of ways.
First, many activities listed as “private activities” under the code are not substitute or competitors for bonds issued on a taxable basis. The list where this would be the case includes nonprofit hospitals and educational facilities, airports, ports, solid waste disposal facilities, affordable and low-income housing bonds, redevelopment bonds, and a number of other types of bonds that are defined as PABs.
How PAB Costs Will Escalate, and Why the Benefits of the Plan are Severely Overstated
If these activities, which clearly relate to governmental activities, had to be financed in the taxable market, borrowing costs would be sharply higher. Most PABs would yield significantly more than equivalently rated corporate bonds if forced to come as taxable bonds. For long-term bonds currently subject to the Alternative Minimum Tax—all PABs except 501(c)3s—the increase in borrowing costs on longer maturity bonds would be at least 150 basis points (assuming the AMT is eliminated). It would be more than that on the large number of smaller PABs: The corporate bond market in which they would have to compete abhors small blocks of paper, and charges a substantial “liquidity premium” on such issues.
For 501(c)3s, the increase in borrowing costs could be as much as 200 basis points. In all cases, of course, the extra cost would rise if interest rates increase as the Fed continues to tighten as expected. The estimated benefit to the Federal government of this change according to Joint Tax, would be $39 billion. For reasons we have discussed in the past, we are confident that this number vastly overstates the Federal revenue benefit of eliminating PABs, while at the same time ignoring the increased costs to state and local governments and qualified non-profit entities such as hospitals and universities if the elimination of PABs were effectuated. A key factor that we believe Joint Tax understates or ignores in their calculation is the already-lower revenue from the issuance of munis under the House and Senate proposals, given sharp cuts in corporate tax rates in the bills.
The Case for Maintaining Private Activity Bonds
In our view, this case is extremely strong. It includes, at the very least:
- The fact that the description of most PABs as being in direct competition with corporate activities funded on a taxable basis is simply factually incorrect;
- The important governmental purpose provided by a large proportion of the sectors defined in the code as “private activities” including (but not limited to) nonprofits, airports, ports, redevelopment agencies, affordable housing bonds, waste disposal facilities, sewerage treatment facilities, and on and on. Natalie Cohen at Wells Fargo has estimated the amount of Private Activity bonds issued for a variety of activities in 2016. Based upon her estimates, $45.4 billion in new-money Private Activity Bonds were issued in 2016, out of a total of $173.4 billion in total long-term new-money financing.
New-money issuance in key sectors, from Natalie’s data, includes:
These totals represent more than 27% of all muni market new-money issuance.
After months of the administration calling for more private capital and tax credits to fund infrastructure the proposal would be designed to cut these same existing programs that have helped issuers fund infrastructure.
As state and local governments attempt to fund the massive amount of needed infrastructure and other related projects, the case for having more tools in the toolbox was and is compelling. In particular, we would make the case that under current and future conditions, the need for public-private partnerships (P3s) to effectively fund projects as technology changes rapidly is going to grow, or even explode. Issuers are going to be extremely challenged to keep up with accelerating technological change in a number of areas. More about that under “the important and growing role of public/private partnerships,” below.
The Important and Growing Role of P3s to Finance Infrastructure
In recent years, infrastructure experts have increasingly begun to recognize the need for state and local governments to partner up with private vendors early in the design, funding, construction and operation of a vast proportion of projects. Quite simply, the private sector has enormous expertise that most state and local governments cannot begin to match, in a variety of sectors and activities. These include:
- Project design
Response to technological change that we expect to turn over every 4-5 years, which will become an increasing factor in the design and maintenance of key projects over time.
New types of governmental services, and new ways to provide it, such as “Transportation as A Service,” which we discussed in some detail in a piece dated August 22.
“Smart city” activities to implement and utilize “big data” and other technology-based techniques.
Proper teamwork between highly technologically advanced vendors and participants and state and local governments is simply going to have to grow over time, to take advantage of and respond to technological change.
This permanent change in the infrastructure landscape is going to be made more costly and more difficult by provisions that limit or eliminate private involvement in combination with tax-exempt financing, such as the current House proposal would surely do.
George Friedlander is Managing Partner at Court Street Group Research. He has more than 40 years of experience as a lead strategist in the municipal industry, previously at Citigroup.View author