The Trump administration’s tax proposal, which calls for lowering the corporate tax rate to 15% from 35%, as well as dropping the top marginal federal rate to 35% from 39.6%, has been greeted with indifference by the municipal-bond market thus far. Both the municipal and Treasury-bond markets have taken the announcement in stride with rates and ratios changing only slightly. We assign a low probability to the passing of a corporate tax-rate reduction to 15% and markets seem to agree. The administration’s proposed tax-reform package and market impact bears watching closely, however, as it winds its way through the legislative process.
Perhaps the most impactful part of the plan calls for lowering the corporate tax rate to 15%. This proposed cut in the corporate rate is significant as the lower tax rate would reduce the appeal of tax-exempt bonds for the insurance companies and banks that hold 14% and 15% of outstanding municipal debt, respectively. Standish believes that while demand from these institutions could decrease gradually as a result of this lower tax rate, widespread selling is unlikely. Accounting conventions should keep insurance companies from rapidly selling off municipal bonds and the favorable risk/reward and liquidity characteristics of these bonds continue to make them attractive investment propositions.
Other provisions of the Trump tax proposal offer even less chance of disrupting the municipal-bond market. A proposed cut in the top individual-income tax rate from 39.6% to 35% would likely have a negligible impact. Previous cuts to top marginal rates, such as those enacted during the Ronald Reagan and George W. Bush administrations, had no discernable impact on municipal-bond pricing; also, historically municipal-bond yields have consistently been higher than the prevailing implied tax rate relative to Treasuries.
Within the tax proposal, the call for phasing out of some deductions—1) state and local taxes from federal taxable income and 2) removal of the alternative minimum tax (AMT)—could have implications for select municipal bonds. We see the potential loss of these deductions raising demand for tax-free municipal bonds from US individuals in high tax states such as California, New York and New Jersey. Furthermore, municipal bonds subject to AMT provisions could get a price boost as those rules are eliminated.
Overall, we believe the potential reduction in demand for municipal bonds from US institutions is likely to be offset by increasing investment from non-US investors. Non-US institutions are increasingly recognizing that US municipals offer attractive yields that compare favorably with more familiar forms of sovereign debt, as well as help deliver portfolio diversification, stable credit quality and relatively low volatility. In our view, these investors are likely to continue as one of the fastest growing buying segments within the market.
In the event that corporate bondholders reduce their municipal-bond exposure as a result of tax reform, which could pressure yields higher, we would view this as a buying opportunity. Furthermore, we believe some allocation to taxable municipal bonds can provide a hedge to the potential outcome of these proposed lower tax rates. We believe that regardless of what happens with tax reform, taxable and tax-free municipal bonds deserve consideration for investment portfolios of both US and non-US investors alike.
The comments provided herein are a general market overview and do not constitute investment advice, are not predictive of any future market performance, are not provided as a sales or advertising communication, and do not represent an offer to sell or a solicitation of an offer to buy any security. Similarly, this information is not intended to provide specific advice, recommendations or projected returns of any particular product of Standish Mellon Asset Management Company LLC (Standish). These views are current as of the date of this communication and are subject to rapid change as economic and market conditions dictate. Though these views may be informed by information from publicly available sources that we believe to be accurate, we can make no representation as to the accuracy of such sources nor the completeness of such information. Please contact Standish for current information about our views of the economy and the markets. Portfolio composition is subject to change, and past performance is no indication of future performance.
BNY Mellon is one of the world’s leading asset management organizations, encompassing BNY Mellon’s affiliated investment management firms, wealth management services and global distribution companies. BNY Mellon is the corporate brand for The Bank of New York Mellon Corporation. Standish is a registered investment adviser and BNY Mellon subsidiary.