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Bonding with municipals

Jan 27, 2017


  • Amid a series of tax reform possibilities, munis will face challenges in 2017, but will maintain a unique tax advantage.
  • We like short to intermediate maturities and flexible strategies in a volatile rate environment.
  • Supply is likely to be manageable in 2017, though demand will be a wildcard given interest rate and policy uncertainties.


Municipal bond investors, even longtime devotees, may be battling feelings of unease in 2017. Policies of the new administration seemingly have the potential to upend long-held muni truisms, particularly those relating to tax treatment. Peter Hayes and Sean Carney address the uncertainties to help you reaffirm your bond with the tax-exempt asset class.

The big question: tax reform

At the top of investors’ worry list are tax reform proposals that could have implications for tax-exempt bonds. The two biggest: A reduction in tax rates for both corporations and individuals, and the elimination or capping of muni tax exemption.

Lower individual tax rates reduce the value of a municipal bond’s tax exemption. 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 benefit lessens the demand for municipal bonds, market valuations would suffer. Tax-exempt munis might need to produce higher yields to attract buyers, all else being equal.

But the market has seen similar, and even more dramatic, tax changes before. The top marginal tax rate was lowered from 50% to 28% in 1986 and from 39.6% to 35% in the 2000s. Of course, investors still reap a benefit over taxable bonds, even at a 33% tax rate.

Munis offer yield benefit, even at lower tax rates
Yields before and after tax

Municipal yields before and after tax

Sources: BlackRock and Bloomberg; as of Jan. 12, 2017. Current Muni Yield is before tax. TEY (or tax equivalent yield) figures show the yield offered by the municipal bond after factoring in a high tax rate of 43.4% and proposed new high tax rate of 33%.

Regarding the fate of muni tax exemption, we see elimination as highly unlikely. States and municipalities rely on municipal debt as a low-cost, efficient way to finance capital improvements and fund infrastructure. The federal government hurts itself if it impedes state and local ability to create jobs, sustain their economies and improve the quality of life for Americans.

Even in the unlikely event that tax exemption were jettisoned, we expect existing bonds would be grandfathered under their current tax treatment. The hazard here is in creating a bifurcated market in which “old” bonds are valued above new issues (essentially assigned a “scarcity value” by the market). Other proposals center on capping the tax exemption at 28%.

Our analysis indicates that any market correction to overcome a drop in the highest tax rate from 43.4% to 33%, or a 28% cap on the tax exemption, would be manageable, potentially requiring some 15 basis points (front end) to 50 basis points (long end) in higher yield to compensate for the reduced tax benefit. The market has digested adjustments of this magnitude in the past without a material change to the overall demand dynamic.

Notably, corporate tax reform (more likely in 2017 than the complicated task of rewriting the individual tax code) could be an offsetting factor. Current law allows companies to deduct interest payments on bond income. Under reform proposals, that benefit may be repealed to compensate for lower corporate tax rates. This could conceivably lead to lower corporate issuance. Munis, in turn, would become a greater source of supply for income-seeking investors. The associated uptick in demand would mute the effect of other tax changes.

Ultimately, “tax reform” is a series of potential scenarios featuring many variables and offsetting factors. Which reforms are implemented and to what degree will determine the extent of the market impact. Uncertainty is perhaps the only certainty, although we can say with enough confidence that munis will retain some tax-exempt benefit. And there will always be an appetite for that very unique feature in an investment asset.



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Peter Hayes
Managing Director, Head of Municipal Bonds Group
Peter Hayes, Managing Director, is Head of the Municipal Bonds Group within BlackRock Fundamental Fixed Income and a member of the Fixed Income Executive Committee.
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