Many investors flock to municipal bonds because of potential tax advantages. While this year’s taxes are probably already done and dusted, Franklin Templeton’s municipal bond team felt it was an appropriate time to revisit the opportunities and risks that recent US tax reform poses for the space. Sheila Amoroso and Christopher Sperry discuss how constrained supply is impacting the market.

As tax season is upon us, we wanted to again highlight why many investors find municipal bonds a valuable addition to their portfolios. In addition, we also wanted to revisit some of the points we made late last year about the opportunities and risks as the effects of US tax reform are felt in its first full year since passage in 2017.

As individuals work through their 2018 tax return filing process, many may be shocked to find they have a tax bill to pay for 2018 when they may not have in the past. This may largely be due to the fact that state and local tax (SALT) deductions—which were not capped previously—are now limited to a maximum of $10,000.

While the marginal tax rates did decline under the new rules, taxpayers from higher-tax states, including states with higher property tax rates, may have been adversely affected. Many impacted investors may be looking for a more tax-advantaged investment to maximize after-tax returns. Municipal bonds look to be a primary choice for those investors. Already this year, the industry has seen more than $24 billion in net muni inflows 1— the strongest demand to start a year since 1992.

The Supply Crunch

As mentioned, there have been opportunities but also risks as a result of the new tax rules’ impact on the municipal bond market. In addition to the expected pick-up in demand for munis, we also continue to see a decrease in supply in the market.

At the end of 2017, we saw a rush of new issues as investors stampeded to complete financings.2 The year-end supply at that time, combined with the inability to complete advanced refundings from January 1 onward, curtailed new issuance in the first half of 2018. This was primarily a result of reduced refunding activity in the market, which caused a decline of more than 20% in year-over-year (YoY) supply in 2018.3