Do Municipal Bonds Believe the Tax Reform Hype?
The bond market is a highly opinionated market. The yields and total return of bond markets reflect investors' sentiments on not only today's prevailing interest rates, but all income over the lifetime of a given type and maturity of bond. For example, a 10 year Treasury Bond's price and yield on the market today have incorporated expectations of all changes to yields and prices for the next 10 years. As opinions of investors change on what is likely to happen to interest rates, we get a clear idea of the consensus on those changes from the bond market. Tax reform is one key factor.
With that in mind, the bond market might be an ideal place to look for Wall St.'s opinions on the probability of the Trump administration's ability to make meaningful tax reforms a reality. Specifically, it is the Municipal bond market that prices in Federal taxes most judiciously. This is because the Municipal bonds are, generally speaking, exempt from Federal taxes. As a result, this market's pricing is greatly influenced by what's known as Tax Equivalent Yield (TEY): the The tax-equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond.
Given how the Municipal bond market has behaved in recent months, we have reason to believe that the market does not believe in the much publicized tax reform efforts of the Trump administration. In fact, according to Standard & Poor's S&P Municipal Bond Index, Municipal bonds have increased 3.45% in value year-to-date. This is after falling substantially in the aftermath of the U.S. elections in November, 2016.
Municipal Bonds reflect investor sentiment on Federal Taxes
Municipal Bonds have increased 3.45% Year to Date
Politicians have speculated on Tax Reform viability all year
The Market's Opinion
Since November of 2016, the Municipal bond market has been roiled by speculation on whether or not Federal tax reform is coming down the pipeline. As we mentioned, Municipal bonds are largely impacted by Federal taxes and expectations about their growth or decline. For example, a California Municipal bond becomes much more attractive to California investors when Federal taxes are high, because they get a double savings on taxes. And the higher the taxes, the more prized those savings will be. If investors anticipate a lower tax savings, however, those bonds will fall in value- why take the extra risk that a Municipal authority will default on bond payments if there's not much to be gained from that extra risk?
We pay specific attention to California because it has a very large Municipal bond market. In fact, high population states that have a heavy state tax burden tend to have very high volumes of Municipal bond investments by individual investors. For instance, the largest Exchange Traded Fund dedicated to California bonds (Ticker: CMF) is larger than all but 7 of the nation's largest Municipal bond ETF's, clocking in at $749 Million in assets to date. There are 19 different Closed End Funds that invest primarily in California bonds currently on the market according to the Closed End Fund Association (CEFA).
The remarks by politicians and media outlets on the probability of tax reform under the Trump Administration have likely made a difference in the market's opinions. Particularly, the market is watching Republicans in the Senate intently, as they are the majority party at the moment and the deciding voice on any tax legislation that may be upcoming. Any kind of skepticism coming out of the GOP is likely to be weighted heavier by the market than positive remarks, as these skeptics are a gauge of party-wide depth of appetite and attitude toward tax legislation.
When Paul Ryan told Fox News on February 2nd, 2017, that tax reform will not happen until later in the year. He laid out that Obamacare reform would have to come first, stating "It's just the way the budget works, and we won't be able to… write our tax reform bill until our spring budget passes.” 1 As with all things Wall St. related, it's impossible to say how deeply these statements animated the markets. Nonetheless, it was headline news for days, and it signaled that Trump's promise of tax reform "within the first 100 days" was not going to be fulfilled.
Then, following the failure to pass legislation reforming the Affordable Care Act in April, Treasury Secretary Steve Mnuchin- a man instrumental in tax reform efforts- stated that the failure to pass ACA legislation meant that tax reform was not forthcoming until later in the year at earliest. He went further, telling the Financial Times that even August was potentially "not realistic." He suggested "by 2018" as the true expected timeline for the administration's tax efforts to become legislation. 2 These remarks- among many others, including Orin Hatch- have not gone unnoticed by the media and Wall St.
National Municipal Bonds
California Municipal Bonds
National Municipal Bonds (Closed End Fund)
Tax Equivalent Yield
Municipal bonds are effectively legal tax shelters in many (but not all) instances. Investors can receive tax benefits in the form of tax deferred growth through formal means, such as investing in a Variable Annuity, for example. Municipal bonds don't have special conditions, and their tax savings are immediate, and this makes them popular with investors. For many Municipal bonds, investors receive a Federal tax exemption and a State tax exemption if the bonds are from the State they live in. A New Jersey resident can receive a tax break on New Jersey Muni bonds, generally speaking. This is a large portion of the pricing and yield of a Municipal bond, and the formula investors use is called "Tax Equivalent Yield."
Tax Equivalent Yield (TEY) quantifies the savings of a Municipal bond over a Corporate bond in a tidy formula. This formula is as follows: the Yield of a municipal bond divided by 1.00 minus federal tax rate equals the TEY. For example, someone in the 33% tax bracket can purchase a Municipal Bond yielding 4% to receive the equivalent of a 6% bond. An investor in the 25% tax bracket would require 8% to match the tax savings of a 6% Municipal bond, etc.
It would appear, from the recovery in Municipal bond indexes since November of 2016, that the Municipal bond market does not believe Tax reform is likely. At least, it doesn't anticipate it any time too soon. It still has not returned to its fully robust pre-election valuation, and that may indicate a modicum of doubt among Muni bond investors in future tax savings for the Muni market. Nonetheless, we can't help but notice that the market has made marked gains as of December, and that should tell us what the bond market really thinks about Tax reform.
Meet the Author & Portfolio Manager
Victor Schramm is a Certified Fund Specialist (CFS®), with expertise in Mutual Funds & Variable Annuity Separate Accounts. He focuses on long term investing geared toward our annuity clients as a Fee Only Investment Advisor. He lives in Portland, OR.