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The Fight to Re-generate Access to Advanced Refundings Continues
Discussions around the ongoing fight to recreate access to advanced refundings through new legislation have been in the news. Steve Benjamin, Mayor of Columbia, S.C., Chair of Municipal Bonds for America (a non-partisan coalition of municipal bond issuers and state and local government officials), and the incoming President of the Conference of Mayors, has been particularly vocal in his defense of advanced refundings.
There are three main components to understand and consider in this discussion:
Munis Not Just Another “Special Interest” Group
- First, as we noted at the time of the Tax Reform legislation, the new tax law and ongoing rounds of proposed budgetary legislation ignore a lot about the role of state and local governments in a construct that includes the Federal government, states, governmental agencies, and cities. Compared to the viewpoint of the drafters of much anti-municipal bond legislation in recent decades, we would make the case that the non-Federal components of this complex aren’t just “yet another special interest at the Federal trough.” Rather, they make up the same set of taxpayers. In our view, too much recent legislation (and not just from the current Administration) has ignored the state and local government role in the Federalist construct. So, we get legislation designed to “save” moneys at the Federal level, even if it costs as much or more at the state and local level. Elimination of advanced refundings that “saves” the Federal government $X billion, but costs state and local governments roughly the same $X billion, saves taxpayers zero billions—but that isn’t how it gets scored in a bill that only looks at Federal costs and savings.
A Painful Choice for State and Local Governments
- Second, potential users of advanced refundings were put in competition with other provisions that were likely to harm taxpayers at the state and local level, including the elimination of private activity bonds (PABs) and the savaging of a portion of the deduction of state and local taxes, and essentially were asked to “choose.” In our view, limits on deductibility of state and local taxes are a form of double taxation, since taxpayers are forced to pay a tax on income paid out as a tax, but double taxation has always been viewed as largely a problem for corporations, not for state and local governments. So, the painful choice was forced upon the state and local partners.
Joint Tax/CBO’s Price Tag Was Vastly Inflated
- Third, the supposed $17 billion the Federal government will save under the tax bill in terms of Joint Tax/CBO scoring through the elimination of these refundings is a massively inflated number. We believe this to be the case for several reasons, including: 1) the fact that roughly 70% of advanced refundings are done less than 2 years before the first call, and 1 ¾ years before the issues become current refundings, and, 2) our conclusion, based on analysis of Joint Tax methodology, that the savings from this change is closer to $3-4 billion, particularly after corporate tax rates have been slashed by 40%. And, as noted above, even that $3-4 billion ignores any increased costs at the state and local level resulting from the change.
The third point we believe, is particularly important as representatives of state and local governments meet with members of Congress in an attempt to resurrect this important financing tool. The starting point for any discussion about how much any such change would cost the Federal government should be $3-4 billion at a maximum, not $17 billion. And the actual net cost, when the benefit of refundings at the combined state and local level is considered as an offset, should be considerably less than that.
Note: Does it matter to the muni market that closed-end muni funds are now trading at a cyclically high discount to NAV?
In another closely watched article from Bloomberg, market participants note that the average discount to net asset value (NAV) among closed-end muni bond funds is hovering over 9%, close to the highest level since 2013.
This pattern generates several questions:
- Why has this occurred? In our view, this is not a credit phenomenon, but largely a reflection of the sharp flattening of all U.S. yield curves, driven by the flattening of the Treasury curve. To be sure, the SIFMA swap index at 1.38% is down from recent highs of 1.72%, but that indexed hovered very close to zero from roughly 2009 through March 2016. At the same time, while long-term yields are up from recent lows, most closed-end muni funds own lots of older paper that is approaching its optional call date. The combination of higher costs of funds and loss of high-yielding bonds to calls generates lower after-fee yields for investors in these funds.
- How does all of this affect the muni market, generally? In our view, hardly at all. The closed-end muni fund sector hasn’t added to the amount of funds outstanding since a very slight “blip” in Q4 2007, and the amount of these funds outstanding is still well below 2004 levels.
- When will the discount close? We would not be surprised seeing an investor own a bit of a closed-end muni fund. But, selection is important, and understanding the types of credits a fund owns is especially important—leverage adds to credit risk as well as market risk.
Note: Markup Disclosure is Now in Effect
Beginning May 14, new MSRB rules on markup on bonds an investor purchases and markdowns on bonds an investor sells must be given to a wide range of retail investors. It remains to be seen how much this new transparency affects the market.
In our experience, most larger firms do not charge markups/markdowns that are going to startle anyone, and the cost-per-year for most direct muni holdings remains less, in many cases, than the cost of having a portfolio managed. Nevertheless, we expect the new rules to have a modest downward effect on liquidity, by driving some additional investors into managed accounts, and by incenting broker-dealers to be even more careful regarding the price at which they are willing to position bonds.
All-in-all, we don’t see this changing the muni market very much. As we have discussed, direct retail is a dramatically smaller proportion of the total muni market than in the past, with more investors moving to funds or separately managed accounts. Ironically, if this new rule drives more retail investors into the managed “space,” longer intermediate municipals, in particular, could become less liquid. That is the maturity range that is a) too long for separately managed accounts, b) too short for most of the open-end bond fund market, and c) where P&Cs, who have become net sellers, used to play their most important role.
Bottom line: Mostly not a big deal, but also mostly not all that helpful, except for investors who bought from firms who tended to overcharge in the first place. And, greater transparency in the municipal space should be a net positive for the industry.
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