In the public interest

With the recent passing of the continuing resolution, the budget focus in Washington has swung to the extension of the Tax Cuts and Jobs Act (TCJA). Signed into law in President Trump's first term, the TCJA’s low tax rates are set to expire at year-end, meaning its extension amounts to trillions in foregone projected tax revenues. With the recent Trump administration and Congressional bias toward fiscal restraint, the search is on to identify expense cuts and increased revenue to reduce the deficit implications. On the extensive list of items under scrutiny is the federal tax exemption of municipal (muni) bonds. Historically, questioning the exemption often emerges when control of Congress flips or when government officials search for new revenue. Though significant change is unlikely, simply debating shifts in tax policy with respect to muni bonds can affect muni market performance.

We think an outright revoking of the tax exemption on all outstanding municipal bonds is highly unlikely. For one, the narrow margins of Republican control in Congress reduce the probability of such sweeping tax policy changes. Perhaps more critically, municipal borrowers are fully engaged in the political process as the exemption greatly reduces the cost of capital for public infrastructure. Many federal lawmakers have served in elected office at the state and local level; they are apt to be sympathetic to states, cities, counties and other public sector borrowers who advocate to protect the muni tax exemption.

Other less-extreme proposals are also on the table. One is limiting the top marginal rate at which one can benefit from tax-exempt income, causing investors in the highest tax brackets to face a new partial tax on municipal bond interest. This proposal has surfaced before—multiple times during the Obama years—but it has never come close to law. Though this more moderate proposal would push up municipal borrowing costs to a much lesser degree than revoking the exemption, municipal issuers are campaigning hard against it. Furthermore, the anti-tax mantra of the Trump administration and Congressional Republicans likely works against introduction of a new tax on top-bracket investors. In all, we think this change has a low probability of passing.

One proposition that might gain traction is ending the ability of private sector borrowers to issue tax-exempt bonds. These “private activity bonds” are issued indirectly by nonprofit hospitals, private universities, certain stadium financings and select companies that use bond proceeds for environmental or economic development purposes. Overall, these private sector borrowers may meet a less sympathetic reception on Capitol Hill in the current political climate. But even if tax-exempt market access is eliminated for certain borrowers, we expect outstanding securities would be grandfathered, meaning only muni bonds issued in the future would receive the new tax treatment.

Despite the low chance for material tax changes affecting munis, this uncertainty has joined heavy issuance, poor seasonal factors and elevated financial market volatility to weaken municipal bond performance. The Bloomberg Municipal Bond Index has posted a total return of -0.55% year-to-date (as of 3/28), in contrast to 2.54% for the Bloomberg Aggregate and 2.63% for the US Treasury indices.

Slim odds aside, we expect the ongoing policy debate to continue to generate headline risk. In fact, further municipal market underperformance eventually may create a buying opportunity.