The recent overhaul of the U.S. tax code effective beginning 2018 has made an early impact on the demand landscape within the $3.8 trillion municipal bond market. Under the new rules, one of the most significant changes is a drop in the corporate tax rate to 21% from 35%, which makes tax exempt municipal bonds less appealing for institutional investors such as banks and property and casualty (P&C) companies. In fact, recent data from the Federal Reserve “Fed” showing the quarterly changes in municipal holdings confirmed that banks reversed a recent buying trend and reduced holdings of municipal debt while P&Cs, somewhat surprisingly, held their exposure steady.
Banks have represented a key demand component for the muni asset class, rising to become the third largest holder at 14% of the total market. The largest holder of municipal bonds is the individual “retail” investor who holds 68% of municipal bonds outstanding, either direct or indirect via investment funds as a proxy. We believe individual investors will continue to drive the muni market as tax reform overall did little to alter the attractiveness of the asset class. Looking ahead, we believe tax exempt municipal bonds will remain a core holding for both banks and P&Cs, although exposure may taper gradually as opportunities within the taxable bond asset class, including treasuries, corporates and taxable municipal bonds, become more appealing from an after-tax perspective.