Tax Reform and Munis: Much Ado About Nothing?

Despite the potential to broadly overhaul the tax treatment of a large swath of the muni bond market, the final legislation actually left most of the municipal bond market untouched. Muni bonds tax-exempt status was never really in jeopardy, but smaller segments of the broader market were targeted for potential overhaul. Private activity bonds (bonds issued by governments that benefit private enterprise, usually used for infrastructure), for example, were elimiated in the House bill, but were spared in the final bill. Only advanced refunding bonds lost their tax exempt status (advanced refunding bonds are a complex way for muni bond issuers to refinance their bonds before their call date).

So What Did Happen?

Tax rates did go down, especially for corporations. However, there are several reasons to think that demand for muni bonds should hold. First, tax reform only modestly reduced indivdual tax rates, which should have minimal impact on whether it makes sense for an indivudal investor to invest in muni bonds versus taxable bonds.  For corporations, who saw a much bigger drop in their marginal tax rate, the question of whether munis continue to make sense is closer and will likely be driven by individual circumstances of particular companies.

Supply and Demand

The tax reform bill may have some indirect impact on both supply and demand in the muni marketplace. Additionally, a potential long-term risk is that as a result of the limitation of state and local tax deduction, that some high tax states and localities may find it politically difficult to raise income or property taxes since those increased taxes won’t be offset by a corresponding deduction.

There is some risk that, at least in the short-term, there may be some potential for supply issues. As a result of the uncertainty surrounding the treatment of muni bonds in the tax bill as it worked its way through Congress, many issuers accelerated their issuance into December 2017, which may have a short-term impact on new supply in the market.

How Does Tax Reform Impact Munis For Me?

For investors in states that have high income or property taxes, it is likely that muni bond’s tax exempt interest may in fact become more appealling as their state and local tax deductions are limited to $10,000 annually.  Without these deductions, many tax payers could see their effective rates rise, and tax exempt income could become more desirable.

Conclusion

As the dust settles after tax reform, muni bond investors can breathe a sigh of relief. Muni bonds still present attractive after-tax returns. It’s unlikely the tax bill passed will have substantial impact on muni  bond returns, and as reflected by a strong 2017 in the face of three rate hikes, muni bonds are resilient in the face of rising interest rates. For investors looking to maximize their after-tax return, muni bonds still represent a powerful tool to meet their goals.