The sleepy municipal bond market could be subject to a rude awakening if Congress succeeds in passing a tax cut bill.
The final bill, if there is one, will most likely impact the supply and credit quality of municipal bonds and the strength of many state and local economies issuing municipal debt, and their housing markets could be hit by falling home prices.
Here’s how the House and Senate bills could impact the muni market:
- The House bill caps the state and local tax (SALT) deduction at $10,000; the Senate eliminates it.
- The House and Senate bills both eliminate advanced refundings, which muni issuers use to refinance higher interest debt not currently callable with lower interest bonds.
- The House bill eliminates tax-free private activity bonds that colleges, hospitals and affordable housing developers use to finance projects, which constitute about 25% to 30% of municipal bond supply, according to Barclays. The Senate bill has no such provision.
Overall there is little good news in either the House or Senate bill for the muni market, with a few exceptions. Neither the House nor Senate tax bill tampers with the tax deductibility of muni bond interest, which is the primary reason investors buy munis and state and local governments issue them.
Both bills eliminate the AMT, which private activity muni bonds were subject to, and both would likely reduce the supply of tax-free municipal bonds, which could boost the prices of tax-free munis already in the market.
The impact on muni bond demand, however, would be mixed. While changes to the SALT deduction could increase demand for munis from investors in high-tax states searching for tax-deductible investments, many taxpayers may no longer need the deduction because they won’t be itemizing deductions due to the doubling of the personal tax deduction, included in both the House and Senate bills. In addition, demand for munis from institutional corporate investors would decline because of the cut in corporate taxes, also included in the House and Senate tax bills.
If Congress passes a tax bill that is close to the House or Senate version, “there will be tremendous pressure on many state and local governments particularly those in the Northeast and on the West Coast,” said Mark Zandi, chief economist at Moody’s Analytics.