Trump? Clinton? We won’t call it. But we do have thoughts on the effect of the candidates’ proposals on the tax-exempt municipal bond market. It turns out, death is a lot more certain than taxes. And another thing seems sure: now is not the time to take a passive approach to investing.
Most investors who buy municipal bonds buy them for their after-tax income and safety—and municipals have generally delivered on both fronts. But tax reform can undermine the value of municipal bonds. For that reason, when changes to the tax code are being discussed, investors should demand flexibility in their bond portfolios.
A TALE OF TWO SHINING CITIES ON A HILL
The tax plans proposed by Hillary Clinton and Donald Trump differ dramatically, particularly around the highest-earning individuals.
The current top federal tax rate is 39.6%. This equates to 43.4% when we combine the highest marginal rate of 39.6% and the 3.8% Medicare tax.
Clinton wants to increase taxes on the wealthiest Americans by enacting a 4% surcharge on income over $5 million and imposing a 30% minimum tax on taxpayers with income above $1 million—the “Buffet Rule.”
In contrast, Trump has proposed to lower the top tax rate. He has released two tax plans to date. His original plan lowered the top marginal rate to 25%. His subsequent plan lowered it to 33%. (We’ve considered both of his tax proposals in the run-up to the election.)
Tax rates affect the yields and prices on muni bonds, which are currently exempt from taxation. On the face of it, Clinton’s proposal should favor municipal bond prices by increasing demand from the wealthiest taxpayers; Trump’s plan should hurt prices by reducing demand.
But their tax plans are more complicated than that.
Clinton is keeping alive President Obama’s proposal of limiting the tax exemption of municipal bonds to 28%. That means that an investor with a top federal marginal tax rate of 43.4% (47.4%, including the 4% surcharge) would pay a tax of 15.4% (19.4%, including the surcharge) on their municipal income.
Trump, although he did not provide details in his initial proposal, had earlier specified his desire to limit the tax exemption of municipals to 10%, thus leaving a 15% federal tax on municipal income. However, because his subsequent plan does not even mention the municipal tax exemption, some political observers believe the exemption could be at risk.
Capping or eliminating the municipal tax exemption or reducing the top marginal tax rate would cause municipal yields to shift higher relative to taxable bonds; at the same time, the value of the bonds would fall, initially (Display 1). The longer the maturity, the greater the initial price impact.
We don’t see this as cause for alarm for actively managed portfolios. Managers that have the right tools in their toolbox—including the ability to add taxable bonds—can cushion this downside effect.
SPENDING MIGHT (NOT) FUEL SUPPLY
Taxes aren’t the only proposals the candidates are making that could affect the municipal market.
Over the past several years, the combination of strong demand in the face of weak supply has been a boon to municipal bond prices. In fact, five of the last six years have seen net negative municipal bond issuance.
That may seem surprising, given historically low interest rates, and the corresponding surge in corporate bond issuance. Yet politicians—unlike their corporate brethren—have not taken meaningful action (Display 2).
But it might not stay that way.
According to the American Society of Civil Engineers, the nation’s infrastructure spending needs through 2020 top $3.6 trillion. And both candidates want to increase investment in our crumbling infrastructure.
Clinton’s plan totals $500 billion. That involves an increase in federal spending of $250 billion, and an allocation of $25 billion to a national infrastructure bank, which would support an additional $225 billion in direct loans. Trump has mentioned investing up to $1 trillion, though he has provided little in the way of detail.
Even with Clinton’s plan, it’s unknown how the increased investment would be funded. Would there be direct spending by Washington or by municipalities—in other words, through municipal or Treasury bonds or some combination? More municipal bonds would test the demand side. Fewer would likely keep the prevailing winds strong, supporting municipal prices.
Clinton also wants to breathe life back into the dormant Build America Bond program, which in 2009 and 2010 provided a federal interest subsidy to municipalities for issuing taxable municipal bonds. During the program’s short life, municipalities issued $181 billion of taxable munis in lieu of tax-exempt issuance.
Reinstating Build America would reduce tax-exempt issuance, which in turn would likely drive prices higher in the municipal market.
THE REAL MANDATE TODAY? FLEXIBILITY.
No matter who wins, there’s little chance our next president will be able to push through his or her entire agenda of tax and infrastructure proposals. But that doesn’t mean anyone should breathe a sigh of relief.
The proposals create heightened uncertainty and volatility for the municipal market, in addition to any realized effects from whatever plans eventually become legislation. That alone calls for an actively managed bond portfolio with a flexible mandate.
Because municipal bonds are the bedrock of an investor’s overall asset allocation, we believe that managers must buffer municipal portfolios against the inevitable speedbumps that lie ahead. That requires active management—and in this case, the ability to use taxable bonds opportunistically. That flexibility can be critical in helping to preserve capital.
However they vote in this election, when it comes to their municipal portfolios, investors will be glad they didn’t set it and forget it.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.