A wary municipal market ponders post-election threats

Market participants are gaming out scenarios in a post-election municipal landscape, pondering potential shifts in the investor base, borrowing costs and whether the Trump administration takes a scalpel or an ax to infrastructure finance tools.

Last week's victory by President Donald Trump coupled with the Republican takeover of the Senate and, as of Wednesday, likely the House, represented in some ways the worst outcome for the municipal bond market, which fears a Red sweep will usher in major tax changes next year.

The likely trifecta also hearkens back to the last Republican sweep, in 2016, which led to the Tax Cuts and Jobs Act, legislation that axed tax-exempt advance refunding and briefly flirted with the elimination of tax-exempt private-activity bonds.

The Republican sweep poses a "material" threat to the tax exemption and protecting it should be the market's top priority, said Matt Fabian, partner at Municipal Markets Analytics Inc.

"The municipal lobby has bulked up," Fabian said. "The muni lobby has improved the data that they have, they have improved the arguments for preserving the [tax] exemption and I think they've been preparing for this potential scenario for months," Fabian said. "So if [the tax exemption] can be defended, they'll do it."

Some market participants are less worried about the loss of the tax exemption but say they're keeping an eye on the possibility that Congress takes a scalpel to carve out certain tools, such as PABs or tax-exempt bonds for health care or housing.

"A full repeal of the muni tax-exemption is unlikely," said Cooper Howard, fixed-income strategist, in a Nov. 12 report. "The bottom line is that it would do more harm than good in our opinion. It wouldn't raise that much revenue, but it would result in higher borrowing costs for state and local governments which would strain their budgets. However, repealing the ability of some issuers to issue tax-exempt debt is a possibility."

Getting rid of tax-exempt PABs or bonds for certain sectors like housing and health care are other potential scenarios where Republicans look to the muni market for revenue to offset TCJA provisions, Fabian said.

If Congress opts to eliminate the tax exemption, the question becomes would be whether it's for future debt or if it's revoked retroactively.

If only new bonds were not allowed to carry the tax exemption, that would immediately raise the value of outstanding tax-exempt debt and broaden the existing buyer base, said Vikram Rai, Wells Fargo's (WFC) head of municipal strategy, in a post-election client call Friday.

In the unlikely scenario where the benefit of tax-exemption gets curtailed, the existing tax-exempt universe would shoot up in value, but new debt would have to come cheaper resulting in meaningfully higher financing costs for issuers" Rai said.

The margins of control of the House and Senate will help determine the size and scope of potential tax law changes that will affect demand for tax-exempt paper. Most experts expect to see tax changes as provisions of the 2017 Tax Cuts and Jobs Act expire at the end of the year and taxes will rise automatically if Congress does not act.

Changes to corporate and individual tax rates, the alternative minimum tax and state and local tax deduction cap will all impact demand for tax-exempt paper.

On the campaign trail, Trump floated the idea of cutting the corporate tax rate to 15% for certain companies, down from the current 21% rate. Any cut would reduce corporate demand for munis.

Considering the potential impact on the buyer base, a cut in the corporate tax cut is "the most relevant of all policies to the muni market," Rai.

Rai noted that after the last cut ? which came as part of the TCJA, which trimmed the rate to 21% from a top rate of 35% ? "corporate demand for municipals dried up considerably."

Banks, insurance companies and property and casualty companies all bought considerably less muni bonds after the TCJA reduction, Rai said.

A reduction to 15% would diminish demand even further. And that carries dangers for a buyer base that's already overly concentrated in retail, he warned.

"It's feast or famine where demand is concerned," he said. "We don't want this concentration in the buyer base because it leads to volatility. That's why it's so important."

But like the tax exemption, the question is whether tax rates are across-the-board or more selective. Trump has said his proposed 15% cut is aimed at stimulating domestic production, which could mean that banks, insurance companies and other taxable corporate investors would not be included in the cut, said Patrick Luby of CreditSights in a Nov. 12 report.

If those buyers are included, it would "undermine institutional demand" and hurt secondary market liquidity, Luby said.

"Such a cut would presumably apply to broker dealers who provide liquidity in the municipal market by carrying inventories of bonds; a reduction in their tax rate would reduce the incentive for them to carry a large inventory, thereby potentially reducing secondary market liquidity."

On the other hand, for retail buyers, the bulk of whom are wealthy individuals, reductions in top individual rates may not carry the same implications.

In a Nov. 11 report, UBS fixed income strategist Sudip Mukherjee noted that the breakeven tax rate ? where the tax-equivalent yield on investment-grade munis equals the yield on investment-grade corporates ? is currently around 30%. That's "significantly lower than the maximum marginal rate of 40.8%," Mukherjee said, including the 3.8% net investment income tax in the calculations. "This suggests that even if top tax rates were lowered, there is significant headroom for munis, with respect to their comparative appeal."

Another tax provision that could impact demand is the individual alternative minimum tax when the current higher AMT exemption, which was enacted in the TCJA, expires at the end of next year.

The individual AMT has "been out of mind for the market" in recent years but its "pending return of the individual AMT" will "once again become a concern for high-income retail investors and will reduce demand for AMT munis," Luby said.

Jessica Lerner contributed to this report