Tax Re­form Would Test In­vestors

The Bond Buyer - - Front Page - BY CHRIS­TINE AL­BANO

Mu­nic­i­pal in­vestors said the House GOP tax re­form bill may cre­ate some op­por­tu­ni­ties, even as it slashes is­suance of bonds and raises credit risk.

The Tax Cuts and Jobs Act (HR1), ap­proved by the House Ways and Means Com­mit­tee Thurs­day, would elim­i­nate tax-ex­empt ad­vance re­fund­ings, pri­vate ac­tiv­ity bonds [PABs] for hous­ing, pri­vate uni­ver­si­ties, not-for-profit hos­pi­tals, cer­tain air­ports, ports, toll-roads, sta­di­ums, and in­dus­trial de­vel­op­ment, as well as tax credit bonds, and al­ter­na­tive min­i­mum tax pa­per.

The Se­nate Repub­li­cans’ tax re­form pro­posal would pre­serve pri­vate ac­tiv­ity bonds and even en­hance them, while ad­vance re­fund­ings would still be ter­mi­nated af­ter this year.

“The big­gest change in the Se­nate ver­sion is the abil­ity of non- for­prof­its like hos­pi­tals to con­tinue to is­sue tax-ex­empt bonds and other pri­vate ac­tiv­ity type en­ti­ties such as air­ports and toll roads to also is­sue tax-ex­empt debt to fi­nance those type of projects,” said Dan Heck­man, se­nior fixed in­come strate­gist Min­neapo­lis-based U.S. Bank. “This makes sense from the stand­point of em­pha­siz­ing In­fra­struc­ture projects in the US. Both the House and Se­nate ver­sions how­ever do elim­i­nate ad­vance re­fund­ing’s, re­duc­ing bil­lions of dol­lars in ad­di­tional bonds that would come to the mar­ket, con­se­quently deny­ing govern­ments the abil­ity to re­fi­nance ex­ist­ing tax-ex­empt debt.”

“The most con­cern­ing as­pect for in­vestors should be the ex­pected de­cline in mu­nic­i­pal bond is­suance mov­ing for­ward as we see the sta­dium bond pro­posal as highly likely of be­com­ing law,” Michael Pi­etron­ico, chief in­vest­ment of­fi­cer at Miller Tabak As­set Man­age­ment, said re­gard­ing the House GOP’s bill last week.

“This po­ten­tial de­cline in is­suance tells us in­vestors are too un­der­weight in du­ra­tion and as such should look to add both cash and du­ra­tion to their ex­ist­ing mu­nic­i­pal bond port­fo­lios,” Pi­etron­ico said.

“If passed in its cur­rent form, the pro­posal would cre­ate a sup­ply night­mare and lead to a wide range of credit is­sues for the pub­lic

fi­nance sec­tor,” Triet Nguyen, head of pub­lic fi­nance credit at New Oak Fun­da­men­tal Credit, in a weekly mu­nic­i­pal re­port on Nov. 3.

He noted that state and lo­cal govern­ments would lose a tool for re­duc­ing their debt ser­vice costs if the elim­i­na­tion of ad­vance re­fund­ing is­suance is ap­proved. As a re­sult, “there might be a ten­dency to re­duce the call pro­tec­tion pe­riod for in­vestors, which will only add to the neg­a­tive con­vex­ity al­ready as­so­ci­ated with mu­nic­i­pal bonds,” Nguyen wrote.

Spec­u­la­tion that a pro­posed re­duc­tion to 20% from 35% in the top cor­po­rate in­come tax will cre­ate less in­sti­tu­tional de­mand for mu­nic­i­pals will be off­set by the re­al­ity that “the mu­nic­i­pal mar­ket is dom­i­nated by re­tail in­vestors,” Heck­man said. “De­mand from in­di­vid­u­als out­weighs de­mand from in­sti­tu­tions.”

That could all change if the House ver­sion of tax re­form be­comes law, ac­cord­ing to a Nov. 6 re­port by Peter Block, man­ag­ing di­rec­tor of credit strat­egy at Ramirez & Co. Block.

He said the bill’s pas­sage prob­a­bly would trans­form the mu­nic­i­pal mar­ket from a largely re­tail mar­ket into a more in­sti­tu­tional mar­ket. He es­ti­mates that un­der the ex­ist­ing bill’s pro­posal, gross tax-ex­empt new is­sue sup­ply likely would de­cline by be­tween 30% and 40% and only be par­tially re­placed by tax­able bond sup­ply.

“Tax­able sup­ply would be struc­tured to ap­peal more to in­sti­tu­tional in­vestors rather than re­tail in­vestors with par coupons, make­w­hole calls, and shorter du­ra­tions,” he said. “The plunge in ex­empt sup­ply would make tax-ex­empts the last re­main­ing le­gal tax shel­ter avail­able to in­di­vid­ual in­vestors -- even if in­di­vid­ual rates re­main 39.6% at the top bracket and/or cor­po­rate rates are 20%.”

Al­though the gen­eral ex­emp­tion for mu­nic­i­pals re­mains, “we can’t help but think that the GOP’s mis­sion was to di­lute the ex­emp­tion as much as pos­si­ble,” Jef­frey Lip­ton, head of mu­nic­i­pal re­search and strat­egy and fixed in­come re­search at Op­pen­heimer Inc., wrote in a Nov. 6 re­port.

Heck­man es­ti­mated that the elim­i­na­tion of pri­vate ac­tiv­ity bonds would re­move be­tween $12 bil­lion and $25 bil­lion in is­suance from the mu­nic­i­pal mar­ket an­nu­ally.

“Al­though it’s not a gi­gan­tic slice of the over­all muni mar­ket, it is in­cre­men­tal,” he said, adding that PAB is­suance is near­ing pre-re­ces­sion lev­els, af­ter dou­bling in 2016 from 2015.

Over the past three years, tax-ex­empt ad­vance re­fund­ing bonds and PABs to­gether ac­counted for an av­er­age of 40% of gross mu­nic­i­pal mar­ket sup­ply, ac­cord­ing to Block.

“The po­ten­tial elim­i­na­tion of tax-ex­empts for this pur­pose is alarm­ing for the mar­ket,” he wrote.

Mean­while, the im­bal­ance of sup­ply and de­mand in the mu­nic­i­pal mar­ket may worsen if the tax re­form gains ap­proval.

“If these tax changes be­come law, the sup­ply/de­mand chasm will widen fur­ther -- as­sum­ing tax re­form does not ap­pre­cia­bly un­der­mine de­mand for the mu­nic­i­pal as­set class,” Lip­ton said in his re­port.

There is a strong ar­gu­ment to buy tax-ex­empt bonds in light of the pro­posed tax re­form – and its im­pact on vol­ume go­ing for­ward, Nat Singer, se­nior man­ag­ing di­rec­tor at Swap Fi­nan­cial Group, told The Bond Buyer.

Pi­etron­ico agreed, say­ing, “some tax de­duc­tions will be done away with and as in­sur­ance against that we urge in­vestors to stock up on the mu­nic­i­pal bond ex­emp­tion as it may be harder and more ex­pen­sive to find in the com­ing years.”

Singer said a tax re­form-in­duced sup­ply slump will be ex­ac­er­bated by the al­ready ex­pected lack of cur­rent re­fund­ings in 2018 and 2019, as vol­ume in 2008 and 2009 was dom­i­nated by Build Amer­ica Bonds -- most of which had make-whole calls rather than stan­dard 10-year calls.

“As a re­sult, there will be less bonds in the mar­ket to cur­rent re­fund in the next two years,” Singer said in an in­ter­view. Com­bined, the dearth in is­suance of ad­vanced and cur­rent re­fund­ings will make it harder for in­vestors who re­main in the 39.6% top tax bracket to find ad­e­quate tax ex­emp­tion for their grow­ing in­come, he said.

That, Singer said, “could crowd more high net-worth in­vestors into the tax-ex­empt mar­ket.”

“Less sup­ply and more de­mand cre­ates a sce­nario where muni bonds may be­come very rich,” and lead to de­clin­ing ra­tios, Singer said.

Heck­man agreed, say­ing that the like­li­hood of the top tax bracket re­main­ing at 39.6% -- on top of a 3.8% Medi­care sur­tax -- “en­hances the need for tax-ex­empt pa­per more than ever” ahead of the po­ten­tial for a sig­nif­i­cant drop in vol­ume if the House tax re­form bill passes in its cur­rent form.

“When a high-in­come in­di­vid­ual is look­ing for ways to min­i­mize their in­come taxes, tax-ex­empt mu­nis are one of the few op­tions,” Heck­man said. “It be­comes even more so the case if these mea­sures pass.”

Heck­man said the sup­ply crunch for in­vestors would be com­pounded by the elim­i­na­tion of tax-ex­empt is­suance by 501 (c) 3 non-profit or­ga­ni­za­tions like hos­pi­tals, higher ed­u­ca­tion fa­cil­i­ties, and nurs­ing homes.

These en­ti­ties have sig­nif­i­cant cap­i­tal needs of­ten fi­nanced by mu­nic­i­pal bonds. “If that pro­vi­sion passes we will see more tax­able mu­nic­i­pal is­suance,” Heck­man said.

Still, some an­a­lysts said some of the bond re­forms could lead to in­creases in price, value, and de­mand – and other tech­ni­cal fac­tors - if the House ver­sion of the bill passes.

“Muni bond buy­ers hit a triple with this news and could fare very well in this pro­posal,” Michael J. Bel­sky, se­nior port­fo­lio man­age­ment di­rec­tor of Mor­gan Stan­ley Wealth Man­age­ment’s Vec­tor Group, told The Bond Buyer on Nov. 7.

“Al­though is­suance might spike to take ad­van­tage of any changes in the law, I ex­pect a marked de­crease in sup­ply, which should keep prices buoy­ant,” he said. “I don’t ex­pect an in­crease in rates as I did pre­vi­ously. Any de­crease in cor­po­rate tax rates that would force rates higher is mit­i­gated by the tighter sup­ply.”

Lip­ton said there is po­ten­tial scarcity value by elim­i­nat­ing cer­tain types of fi­nanc­ings, which can pro­duce tighter spreads within these sec­tor cat­e­gories.

Heck­man said the in­crease of tax­able is­suance by 501 [c] 3 en­ti­ties un­der the new House bond re­forms could turn into a pos­i­tive for in­vestors since the void “will in­crease the value of cur­rent tax-ex­empt bonds and any fu­ture is­suance of tax-ex­empt bonds.”

Both the elim­i­na­tion of PABs and tax-ex­empt is­suance by 501 [c] 3 en­ti­ties “could add to the ap­peal and at­trac­tion of ex­ist­ing and any fu­ture is­suance of tax-ex­empt bonds,” Heck­man added.

“Should this fi­nanc­ing ve­hi­cle be spared the ax, it may ac­tu­ally ben­e­fit from the spillover de­mand for yieldy in­stru­ments,” Nguyen said of the pro­posed elim­i­na­tion of tax ex­empt is­suance by the non-prof­its.

The sup­ply cur­tail­ment could also ben­e­fit all out­stand­ing tra­di­tional high yield mu­nic­i­pals, ac­cord­ing to Nguyen, but he said, the in­vest­ment grade por­tion of the mar­ket may not fare as well.

“The po­ten­tial re­peal of the AMT should lead to out­per­for­mance by bonds sub­ject to the AMT, as the yield on those bonds would con­verge to­ward pure tax-ex­empt yield lev­els,” he said. In ad­di­tion, “the pro­posed elim­i­na­tion of PABs and sta­dium bonds should boost the scarcity value of yieldy pa­per.”

Buy­side an­a­lysts said they were sur­prised to see the pro­posed elim­i­na­tion of new PAB is­suance af­ter it was pre­vi­ously considered the so­lu­tion to a $1 tril­lion in­vest­ment in in­fra­struc­ture via pub­lic-pri­vate part­ner­ships, but were not sur­prised by the elim­i­na­tion of tax-ex­empt sta­dium-bond fi­nanc­ings.

“The [Trump] ad­min­is­tra­tion was push­ing pub­lic-pri­vate part­ner­ships as a way of achiev­ing max­i­mum op­er­at­ing re­sults,” Bel­sky said.

“Mar­ket par­tic­i­pants were com­pletely blind­sided by the pro­posed elim­i­na­tion of tax ex­emp­tion for ad­vance re­fund­ings and for pri­vate ac­tiv­ity bonds,” Nguyen said.

As a per­cent­age of to­tal sup­ply, ad­vance re­fund­ings have been on a de­cline, ac­cord­ing to Nguyen. “Any fur­ther re­duc­tion in sup­ply will only ex­ac­er­bate the al­ready tight tech­ni­cals in our mar­ket,” he said.

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