Tax Reform Shakes Up the Muni Market Landscape

The passage of the largest overhaul of the U.S. tax system in decades dominated headlines in December 2017. The process provided a wild ride for muni market participants and its longer-term impact is still up for debate. But as we’ve talked to portfolio managers since then, it’s become clear that most aren’t expecting a disaster for muni investors, although there have been some big changes.

What Happened? Early versions of the bill included the elimination of the tax exemption for both private-activity bonds and advance refunding bonds, keeping both muni issuers and buyers on edge. Private-activity bonds provide vital project financing for various types of facilities including nonprofit hospitals, utilities, multifamily housing units, and charter schools. As PABs account for an estimated 20% to 30% of the overall muni market, and advance refunding bonds generally compose 10% to 25% of annual muni bond issuance, disallowing either financing tool was expected to have an outsize impact on muni participants.

While the final version of the legislation ultimately spared PABs from significant change, it did eliminate the tax exemption for advance refunding bonds. Municipalities issue advance refunding bonds when interest rates on their existing debt are higher than those available in the market, yet their outstanding bonds aren’t currently callable. To realize savings, issuers sell new bonds and use the proceeds to make coupon payments on the original bonds until the call can be exercised.

Impact on the Muni Market The debate over the tax changes alone was enough to spur a flurry of activity in the muni market during the final weeks of 2017, the impact of which will be felt throughout the next year. The result was record bond issuance in December which totaled more than $69 billion (more than triple the new muni issuance in December 2016) as issuers rushed their bond deals to market ahead of the new tax bill's start on Jan. 1. That, together with the spike in issuance, has prompted many to predict a dearth of muni-bond issuance in 2018. In fact, muni-bond issuance in January 2018 dropped to $20 billion, which is down roughly 45% from the first month of 2017.

That should bode well for current muni-bond investors if demand holds up. While the muni market did see some outflows in December, net flows into open-end muni funds turned positive for the month in January 2018 to the tune of $7.9 billion. Yet certain aspects of the tax-reform package could dampen demand, at least from corporate buyers. The new legislation cuts the corporate tax rate to 21% from 35%, which could mean a drop in demand for muni bonds from large buyers such as banks, property and casualty insurance, and life insurance companies. According to Sifma, these firms owned about $1.1 trillion of muni bonds (roughly 30% of the market) as of mid-2017, so the impact of lower tax rates could be meaningful.

That said, muni market participants aren’t predicting disaster. Hugh McGuirk, head of the municipal bond group at T. Rowe Price—which manages