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Washington takes on tax reform. What does this mean for the municipal bond market?

February 24, 2017

With a new administration taking office in January, you're already seeing some of the effects these political and economic changes in Washington are having on the bond markets.

In just a matter of days after the November election we saw bond prices tumble as bond yields increased dramatically. The yield on the benchmark 10-year Treasury bond rose nearly 50 basis points, jumping from 1.83% to 2.30%. And, in an extremely unusual occurrence, pre-tax municipal bond yields were actually trading above Treasury yields. Since the election, the 10-year portion of the AAA-rated municipal bond curve rose from 1.72% to 2.45% over the month of November, retreating somewhat to 2.35% in December, both representing a higher increase relative to the movement in the Treasury curve.

While the increase in yields caused downward pressure on municipal bond prices over the short term, we've seen a bounce back in total returns for the asset class in December. This volatility is something that may linger throughout 2017 as uncertainty could rule the landscape.

Muni AAA Benchmark Yield Curve

Municipal benchmark yield curve

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Bloomberg Barclays municipal indicesNovember 2016
Total return
December 2016
Total return
Municipal Bond Index –3.73% 1.17%
3 Year –1.28% 0.28%
5 Year –2.68% 0.50%
10 Year –4.48% 1.43%
20 Year –4.21% 1.71%

In fact, any discussions regarding the impact the new administration and an all-Republican Congress will have on the bond market—in particular the municipal bond market—seem to come with more questions than answers.

What's driving this unusual behavior in the municipal bond market?

Markets experienced their first meaningful increase in rates in quite a while immediately after the election. This large increase in rates was mostly a byproduct of the market pricing in more optimistic expectations for economic growth from expected expansions in fiscal policy. Heavy tax-loss selling at year-end was another contributing factor. With municipals trading more cheaply, buyers started coming back into the market in late November and early December 2016.

How will proposed tax-reform measures affect the role of municipal bonds?

Tax reform is a reported priority area for the incoming administration. There is a proposed overhaul of the tax code with decreases in tax liabilities for both individuals and corporations. Additionally, there's the potential for increased bond issuance to help support the infrastructure spending being proposed by the Trump administration. However, there is still a lot of uncertainty on how this will impact tax-exempt municipal bonds.

The Republican-controlled House has proposed reducing marginal tax rates for individuals and corporations. On an individual basis, we don't believe that the plan to reduce the number of tax brackets from six to three will have a meaningful effect for municipal bond investors. Unless tax rates drop to unexpected levels, municipal bonds should remain an attractive option on a risk-adjusted return basis, even for those in a proposed 33% bracket.

On the corporate side there is a proposal to lower the corporate income tax rate from 35% to 15%. This has the potential to affect demand as muni bonds would become less attractive relative to corporate bonds, especially for institutional buyers such as banks and insurance companies. At a 15% level, this may have the potential to lead to mild upward pressure on yields, resulting from increased demand.

There has also been some discussion calling for a cap on the level of tax deductions, bringing the municipal exemption into play. One proposal has a cap on deductions above a specific level. Another proposal places a 28% cap on the exemption, which would effectively impose a 5% tax on otherwise tax-exempt interest for investors in the new 33% tax bracket.

Chris AlwineReducing the value of the exemption is a possible scenario that will lead to higher municipal yields and lower values for bond owners. According to Chris Alwine, head of Vanguard Municipals & Credit Research, "If these reforms are implemented, the value of the tax exemption would be reduced. Markets would react by demanding higher yields to own municipal bonds, which is expected to return the value of the tax exemption to levels close to where they were before. Recently, however, signs seem to be pointing toward the tax exemption likely surviving in its current form. We plan to keep a close eye on this and other tax reform proposals as the year unfolds."

Will increased infrastructure spending have an effect on the muni market?

Ed SaracinoThe new administration is also pushing for increased spending on infrastructure, leading to an increase in fiscal spending, and municipal bonds are the primary source of funding for such projects. According to Ed Saracino, senior product manager for Vanguard's municipal bond funds, "Rebuilding the nation's infrastructure appears to be a priority of the new administration; however, specific areas of focus and details on financing have not emerged at this time. We anticipate getting more clarity as the debate evolves."

What does this mean for your bond portfolio?

As always, keep in mind the value of sticking with your long-term plan and resist acting on short-term returns or the daily headlines. Municipal bond can funds offer relative stability and income potential, something you may be seeking in this period of political and economic uncertainty. We believe that municipal bond funds remain an important component of a diversified portfolio, especially for those seeking a low-cost, steady stream of tax-free income.

Notes:

  • All investments are subject to risk, including the possible loss of the money you invest.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
  • Although the income from municipal bonds held by a fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
  • Past performance is no guarantee of future returns.
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