The recent changes to the U.S. tax code are likely to have a ripple effect within several areas of the fixed income markets. We believe most affected will be municipal bonds.
Lower tax rates make taxable bonds more competitive with tax-advantaged bonds when comparing relative yields. Over time, we expect the municipal market will cheapen relative to the taxable bond market.
Though the tax decreases were small for individuals, the decrease in the corporate tax rate to 21% makes municipal bonds substantially less attractive to insurance companies and banks. These institutional buyers represent a significant portion of the demand for municipal bonds, especially bonds with maturities longer than ten years. This is very good for individual investors, as they should be able to get higher yields even though their tax brackets did not change significantly.
Elimination of SALT
The elimination of state and local tax (SALT) deductions makes it more important for investors to buy municipal bonds that are exempt from their home state tax. This is especially evident in high-tax states. As an example, let’s look at an investor receiving a 5% tax-free coupon in a state with a 7% income tax.
Under the old tax laws, the investor would have had to pay 35 basis points of state tax on out-of-state bond interest. However, the 35 basis points paid would have been deductible against federal taxes as part of the investor’s SALT deductions. Under the 2018 plan, there is no longer a federal deduction. The net result is bonds issued in high-tax states such as California will be relatively more expensive (have lower yields) than the index average yields. This favors active management and customized portfolios.
“Advance refunding” is when a municipal authority issues new debt at lower interest rates to defease old debt. This typically results in an immediate (present value) cash flow to the budget. With the elimination of advance refunding in the 2018 tax code, municipalities will now have less flexibility in managing their budgets.
Historically, advance refunding has been one of the most abused financial processes, with many investigations, sanctions, and fraud accusations. Elimination of advance refunding is an effort to clean up a very dirty corner of the municipal bond business. And this is good for the long-term sanctity of the municipal bond business though a slight credit negative in the near term.
The majority of corporate taxable bonds are held by tax-free accounts. Hence, there should be only a small impact in this area due to the tax code changes. Insurance companies and banks may be more likely to buy corporate debt over equities, as the new corporate tax rate and the dividend rate gap is mostly gone. As stated above, these entities are now more likely to buy corporate debt over tax-advantaged municipal debt.
The Supply Side
On the supply side, every corporation will have to re-evaluate whether they are better off raising money through debt or through equities. We have no idea how companies will view the decline in value of the interest deduction (due to lower corporate tax rates) compared to equity dilution. But this is the exercise the accountants and actuaries are likely to be going through. Clearly, the higher a company’s 2017 tax bracket relative to their 2018 tax bracket, the more likely they are to consider reducing debt sales and increasing equity raises. This can also be impacted by dividends, which are not deductible. The bottom line is that profitable, historically highly taxed, companies with no dividends on equity may shift some capital needs from debt to equity. Only time will tell if it plays out this way.
Finally, the mortgage interest cap for deductible interest was lowered, and this is likely to lead to slightly lower supply. However, we see no major impact to the mortgage bond markets.
This information should not be considered to be an recommendation to buy or sell a security or to adopt a particular investment strategy.
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The opinions expressed are those of the Clark Capital Management Investment Team and are subject to change without notice. Clark Capital does not provide tax, accounting, or legal advice to our clients or investors, and all clients and investors are advised to consult with their tax, accounting, or legal advisers regarding any potential investment. Clark Capital reserves the right to modify its current investment strategies based on changing market dynamics or client needs. The material in this report has been derived from sources considered to be reliable, but Clark Capital cannot guarantee its completeness or accuracy.