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Uncertain Outlook for Muni Bonds in 2017

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The municipal bond market may have a lot more to worry about than just rising interest rates next year, which have already hurt it more than many other domestic fixed income markets.

There’s the possibility that the new all-Republican Congress, with the blessing of President Donald Trump, will reduce or eliminate the tax-exempt status of municipal bond interest as part of a broader tax reform program. 

President Barack Obama sought to limit the exemption to 28%, and Trump had expressed openness to a 10% limit early in his campaign, but in a mid-December meeting with a group mayors Trump reportedly said he would retain the tax exemption on the interest that municipal bonds pay investors.

Still, Christine Todd, president of Standish, an investment boutique owned by BNY Mellon, is worried. Writing in Barron’s on Dec. 19, she noted,  “The question of whether munis should be tax exempt arises when tax reform is taken up in Washington.”

In addition, the tax reform agenda of Trump and Republican congressional leaders cuts personal income tax rates, which will lessen the value of the muni bonds’ tax exemption.

Todd worries that since those proposed tax cuts would slash government revenues by several trillion dollars, the new administration could look to limit the muni bond tax exemption to make up some of those revenue losses.

But elimination of the muni tax exemption is seen as highly unlikely, according to analysts at BlackRock and other financial firms.

There is, however, uncertainty about the impact of Trump’s plans to spend $1 trillion on infrastructure over 10 years on the municipal bond market. A plan that involves new, large issues of municipal bonds would likely damage the market by flooding it with more supply, but a plan involving tax credits for private companies, which has been suggested by Trump, may not necessarily be positive for munis.

Trump’s policies overall are a “negative for U.S. public finances” because of uncertainties about the details of his proposals, according to Fitch Ratings.

“The reality is that it will take time for Trump to forge a productive working relationship with Congress,” writes John Mousseau, director of fixed income at Cumberland Advisors. “Cutting marginal tax rates, designing an infrastructure program and a plan to finance it will take time. And it will take a while to get a growth rate from its current 3% to be above 4%.”

He says municipal bonds currently are a “giveaway” for investors. A 4% tax-free yield is equivalent to 6.6% taxable yield for investors in the top federal income tax bracket and even higher if state income taxes and, for some, the Medicare surtax are included, writes Mousseau.

Still, Patricia Healy, senior vice president of research and portfolio manager at Cumberland Advisors, writes that it’s important to choose high-quality municipal bonds now.

Reform of the Affordable Care Act, which Trump and Republican congressional leaders have championed, could affect the credit of certain hospitals and states that have expanded Medicaid under the law, so Cumberland continues “to invest only in high-quality hospitals that have strong liquidity and a reasonable acquisition and growth strategy,” writes Healy.

The firm is also emphasizing muni investments in essential service revenue bonds because of the “number of outside factors that can affect credit quality of general obligation muni bonds,” writes Healy.

A number of states and municipalities have already seen downgrades in the fourth quarter. including New Jersey, New Mexico and Dallas, recounts Healy. At the same time, states and municipalities are trying to tackle pension funding issues and CalPERS, California’s largest pension fund, and other pension funds have announced they will reduce assumed rates of return, which can help in the long run but more immediately decrease projected funding levels.

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