Municipal bonds, like all fixed income assets, took a hit after Donald Trump’s surprising presidential win, but they could face additional pressures unique to them.
Most municipal bonds are tax-exempt –- their interest payments are not taxable — making them an especially valuable asset for investors in the top tax brackets, such as the high net worth clients of financial advisors.
Trump’s plans to reduce the number of marginal tax rates from seven to three and the top marginal tax rate from 39.6% (excluding the 3.8% Medicare surtax) to 33% will also reduce the value of munis’ tax-exempt benefit. His tax plan provides few details on which deductions will be eliminated or reduced which is worrying some muni market participants who fear that the exclusion of muni bond interest from taxes could be capped or eliminated.
A 5% yield on a muni bond is currently worth 8.27% to an investor in the top 39.6% federal income tax bracket and even more if state income taxes were included. Under Trump’s proposed tax regime that same 5% yield would be worth only 7.46%.
John Mousseau, director of fixed income at Cumberland Advisors, cautions, however, that tax cuts will take time to pass Congress, muni yields have already backed up more than usual and if “tax loopholes and deductions are removed [in the next Congress] the net effect may be that munis are only game left in town.”
Whatever happens to tax rates and deductions, muni bond investors will still face growing credit risk related to the pension liabilities of state and local governments. Those liabilities have been growing and currently stand at anywhere between $1.8 trillion, according to the Federal Reserve, and $3.3 trillion, according to Moody’s.
Using the Fed’s calculations, state and local governments have approximately $3.7 trillion on hand to service $5.5 trillion in pension liabilities.
State and local governments have been increasing contributions to pensions but their liabilities have continued to grow nonetheless due to low interest rates, intentional underfunding and longer lifespans of retirees, according to a report from McDonnell Investment Management.
”Defined benefit plans were created with the intention that state and local governments would set aside adequate contributions to provide retirement benefits for the employees in the future” but without marking assets to market and using instead a 5-year moving average to “smooth assets,” the funding ratios of many pension funds “were greatly overstated,” according to the report. New rules now require more disclosure about funds’ balance sheets.
The report stresses the importance of credit research for muni bond investors to identify both the risks and opportunities in the market — to know the amount of unfunded liabilities, the risk profile of investments, expected long-term rates of return (too optimistic?) and government reform plans to reduce pension liabilities.
Even Dallas, fastest growing U.S. city among the country’s thirteen largest, is facing a crisis in its pension fund for police officers and firefighters, according to a story in The New York Times. Nervous city retirees pulled $220 million out of the fund following a recommendation in July against letting retirees withdraw big blocks of money. The pension system recently asked the city for a $1.1 billion infusion of money to strengthen the system, a request Dallas Mayor Michael Rawlings called “ridiculous.” The request is equivalent to the city’s total general fund budget.
In contrast to a potentially deteriorating situation in Dallas is the situation in Puerto Rico, which did default on $1.8 billion worth of muni bond earlier this year. Some Puerto Rico general obligation muni rallied to their highest price in almost 17 months after the island’s newly elected governor, Ricardo Rossello, said he favors paying bondholders interest if they can wait longer for principal payments. Long-term general obligation bonds with a 5% coupon rallied to trade at 65 cents on the dollar, nowhere near par but their highest price in almost 18 months.
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