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.