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President Donald Trump’s tax plan is unlikely to trigger a frenzied municipal bond sell-off even if it includes provisions that negatively impact the exempt bond market, analysts told Bloomberg BNA.
Conflicting messages on tax reform from high-level officials in Trump’s administration have desensitized the market, Citigroup Inc. analysts Vikram Rai, Jack Muller and Loretta Bu said in an April 24 note to clients. “Now investors seem to shrug off statements from the administration regarding tax-reform” though they haven’t completely discounted that an overhaul could happen eventually, they said.
Rai told Bloomberg BNA April 25 that investors have begun to realize how difficult it will be to overhaul the tax code, especially with such a divided Congress. “I don’t think we’ll see a very sharp reaction from the bond market or the municipal market,” he said. The opposite would have likely been true had Trump’s tax plan been unveiled six months ago, Rai said.
Trump is scheduled to release his plan April 26, but it will provide only an outline of a more detailed plan expected in June.
Matt Fabian, a partner at Municipal Market Analytics Inc., agreed that the plan is unlikely to cause huge waves in the municipal bond market.
Achieving comprehensive tax reform before year-end seems less plausible than it did immediately after Trump was elected, he said. There haven’t been any congressional hearings on potential tax reform provisions and no bills have been introduced, Fabian said.
Even if some investors sell off their municipal bonds as a result of Trump’s tax announcement, history shows that these types of reactions aren’t always lasting.
“The municipal bond market reacted strongly in November in the aftermath of the election as investors pulled money from the sector, causing yields to rise significantly relative to Treasuries,” Benjamin Streed, a fixed-income strategist at Raymond James Financial Inc., said in an April 25 email. But this sell-off reversed over the last few months, he said.
“The data indicate that investors appear more comfortable with short and intermediate maturities, but overall the initial sell-off might’ve been a bit overdone,” Streed said.
Recent strength in the municipal market may indicate that, while investors seem to know tax reform is still on the docket, they expect the overhaul to be less extreme than initially thought, he said.
For example, during the week ending April 12 municipal bond funds saw inflows of $1.63 billion, according to Thomson Reuters Lipper, Streed said. “This marks the third largest inflow on record and most since 2009,” he said. And “although we haven’t undone the outflows since the election, muni markets are recovering as investors continue to seek out high-quality, income producing, tax-exempt assets.”
Expectations of the tax plan are for a “bird’s eye view,” Streed said. “Investors care about specifics. Those specifics, whenever they arrive, will be critical. At this juncture there are likely to be many unknowns in the plan.”
One provision the Trump plan is expected to include is a 15 percent corporate tax rate, which could be an especially divisive issue among lawmakers, Rai said. The deficit hawks in the Republican party “understand that a lower corporate tax rate will increase the cost of tax reform because every 1 percent cut to the corporate tax rate costs the federal government $100 billion” over a decade, he said.
A 15 percent corporate rate would also negatively impact the municipal bond market, if enacted.
Banks and insurance companies are the primary crossover buyers of municipal bonds, Fabian said. Cutting the corporate tax rate to 15 percent would reduce the value of a municipal bond’s tax exemption and the after-tax benefit to those companies, he said.
At the beginning of the tax reform discussions, issuers were concerned that municipal bonds could lose their exemption in order to pay for other parts of the tax plan, but those fears have subsided, the analysts said.
“The risk of tax reform damaging the exemption is relatively low,” Fabian said. “But if we’re wrong, then the potential correction would be harsher because most of the market is expecting the same thing to happen.”
Fabian said while he doesn’t anticipate that the municipal bond market will react strongly to the Trump tax plan, there could be “moderate” negative effects.
“I think it’ll tend to trend negative because investors who have put their money into equities in the belief that tax reform is going to happen are going to be consoled by the president talking more directly about tax reform,” he said.
It will perpetuate the “risk-on” trend—meaning investors engage in higher-risk investments like stocks—that started when Trump took office.
As a result, Treasury bond prices could fall and “munis will tag along” because they trade closely with respect to Treasuries, Fabian said.
Additionally, talks of a tax plan that isn’t deficit-neutral could be a red flag to muni investors. Increasing the deficit would prompt the government to issue more Treasuries in the long term to generate revenue—increasing supply and reducing demand. Adding to the deficit could also jeopardize the U.S. credit rating, he said.
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The Citigroup client note is at http://src.bna.com/ofs.
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