What does Trump’s win mean for the US municipal bond market?
The hotly-contested election is finally over and a new time of uncertainty begins. Although it may be some time before we see the priorities that the President will advance in his agenda, it is reasonable to believe that tax reform will be on the docket
What does Trump’s win mean for the US municipal bond market?
The hotly-contested election is finally over and a new time of uncertainty begins. Although it may be some time before we see the priorities that the President will advance in his agenda, it is reasonable to believe that tax reform will be on the docket.
Tax reform was one of the less contentious issues on the President’s campaign platform. Both Republicans and Democrats would like to see a change in taxes. Republicans would like to lower tax rates and recognize that broadening the base (reducing exemptions) may be the path to achieving lower rates. Democrats would like the wealthy to pay more, but are amenable to lowering taxes on the middle class if the wealthy are paying their fair share.
Potential policy impact
Much remains to be seen in terms of what actually comes to fruition, but we have analyzed the potential impact on the municipal market based on the policies proposed during the campaign.
Trump’s platform essentially proposes a total overhaul of the tax code, with significant reductions in tax liabilities for individuals and corporations. For the purposes of this analysis we are primarily focused on changes for individuals as this is the area that will have the greatest impact on the municipal market.
There are a number of elements to the plan, but generally the proposal makes the tax code less progressive by significantly reducing marginal tax rates and reducing itemized deductions. Specific details of his plan are outlined in table 1.
Source: Moody’s Analytics.June 2016
Replacing the current seven personal income tax brackets with three and reducing the top marginal rate from 39.6% and 25% carries the greatest risk to the municipal market. The lower the tax rate, the less valuable the municipal exemption is to investors as lower tax rates reduce the size of the liability that investors can shield. The majority of municipal bond investors are in higher marginal income tax brackets which would be reduced going forward. As the value of the tax exemption falls for the large majority of municipal bond holders, it is likely that yields would rise in order to continue to make municipals attractive to investors. This rise in yield would cause the value of municipal bond holdings to fall.
The second part of Trump’s plan calls for caps on the level of tax deductions. While it is not clear if the exemption for municipal income will be included in tax reform, it is not a far stretch to believe that it could be. The municipal exemption is broadly viewed as a loophole that benefits the wealthy. As a result, eliminating or capping the exemption would more readily gain public approval. Reducing the value of the exemption is the equivalent of imposing a surtax on municipal income. This again leads to higher municipal yields and lower values for bond holders.
Another implication of a Trump presidency encompasses the wider market and as a follow-through, the municipal market. In addition to lower tax rates, Trump has proposed increases in infrastructure and defense spending, leading to increased fiscal spending. This could cause the economy to accelerate, leading to higher growth and higher inflation. This in turn would lead to higher risk-free yields in the Treasury market. Municipal yields typically follow the Treasury market, albeit with a lag, and would likely subsequently rise.
Higher yields from a growing economy would further exacerbate the lower valuations associated with the change in tax rates. Greater fiscal spending in certain areas such as infrastructure could also cause an increase in supply which would further weaken the technical conditions that have driven the market for the last several years. The amount of issuance could be diminished by the rise in yields if municipalities refrain from new deals given the greater cost of issuance. It is not clear which factor will play out most significantly.
The municipal market has been driven by technicals: a low level of supply coupled with a high level of demand. Performance has been strong and the market has experienced a period of low volatility and slow growth. We believe we are in an environment in which a decline in the value of municipals coupled with rising rates could cause outflows similar to those witnessed in 2010 (Meredith Whitney) and 2013 (Taper Tantrum).
A fall in demand (outflows) would upset the current strong technicals which have been driving the market and begin a spiral downward. As noted, there is some possibility that fiscal stimulus could cause macro improvement. This could support a buying opportunity such as existed in those periods, but we would note that flow cycles tend to last longer in municipals. Once outflows begin, a catalyst is typically needed to stem the tide.
The road ahead
Historically, it is difficult to make progress on a number of campaign issues so it remains to be seen what will actually transpire. That said, we believe that tax reform will be a more palatable proposal to the House and Senate versus some other policies outlined on the campaign trail. As such, it is more likely that the President will be able to make progress in this space.
The amount of dislocation in the municipal market will vary depending on the size of the tax cut and the decision regarding caps or removal of the exemption for municipal income.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.