Lower taxes could hit municipal bond yields

Individual and corporate tax reform add uncertainty to staid market

Feb 13, 2017 @ 12:10 pm

By John Waggoner

The one drawback to lower tax rates: Muni bond prices could take a hit, according to Peter Hayes, BlackRock's head of municipal bonds.

People buy municipal bonds primarily because their interest is free from federal, and sometimes state, income taxes. The tax-free feature allows states to raise money at lower interest rates than they otherwise could, and allows clients to reduce their tax burden.

Tax reform is a longtime piece of the Republican platform, and President Donald J. Trump has promised a “phenomenal” announcement on taxes in coming weeks. Presumably, this would include a tax break for individuals as well as a reduction in corporate taxes.

“The hard truth: Lower individual tax rates reduce the value of a municipal bond's tax exemption,” Mr. Hayes wrote in his BlackRock blog. “For example, a drop in the top tax rate from 43.4% to 33% means $4,340 in annual savings would be reduced to $3,300. And to the extent that lower tax-exempt benefit mutes the demand for municipal bonds, market valuations could suffer.”

Even with both houses of Congress in Republican hands, however, it could take a long time to craft a bill that will reduce taxes and not send the debt and deficit spiraling. The market might need to offer 0.15 percentage points to 0.5 percentage points in additional yield to compensate for lower tax rates.

And Mr. Hayes gives 10% to 15% odds that Congress would eliminate the tax-free feature from municipal bonds. If Congress were to eliminate the tax-free feature of muni interest, it's unlikely they would kill that feature from existing bonds.

“They would have to change the nature of something created long ago, and that would set a bad precedent,” Mr. Hayes said. “The market would likely bifurcate, with old tax-free bonds trading infrequently, and new, higher-interest munis being more actively traded.”

Corporate tax reform could add additional wrinkles. One way of making lower corporate rates revenue-neutral would be to eliminate the interest deduction companies take for bonds. Eliminating that deduction could mean lower corporate issuance, putting munis in greater demand.

Corporate tax reform might take precedence over individual tax reform.

“It would act as an economic stimulus and would be less complicated to do than tax reform for individuals,” Mr. Hayes said.

Making individual tax rates revenue-neutral could require difficult options, such as eliminating the deduction for mortgage interest.

“There's a whole host of different outcomes,” Mr. Hayes said, depending on what actions Congress takes. Because of that, trying to take action now would make little sense. And so far, he said, most advisers aren't worried about the effects of tax reform.

“They're much more concerned about rising interest rates,” he said.

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