INSIGHTS

On November 16, 2016

Trump Presidency and Municipal Bonds

Unsurprisingly, there have been a lot of questions and speculation about the impact of the Trump Presidency and his tax plan upon the municipal market. Specifically, what effect does lowering the highest federal tax bracket from 39.6% to 33% have upon municipal investors?

In short, when previous administrations (Ronald Reagan 1981 and George W. Bush 2001) lowered income tax rates the markets demonstrated similar patterns…to some degree. One important consideration is that no event happens in a vacuum. Various factors affect how the market responds to each scenario. To wit, personal income tax cuts were also combined with cuts in capital gains, dividend and estate tax rates. Furthermore, the absolute level of rates (yields in the bond market), prior tax rates and points in the economic cycle vary from period to period.

The Reagan-era Economic Recovery Act of 1981 (ERTA) – among other changes – lowered the top federal tax rate from 70% to 50% (not a typo – that was reality back then). It also included major cuts to estate taxes and corporate tax rates.

The George W. Bush-era Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) essentially lowered the federal tax rates as follows for the top brackets to be phased in over several years:

• 39.6% lowered to 35%


• 36% lowered to 33%


• 31% lowered to 28%


• 28% lowered to 25%
  
  
  
  

Additionally, it included tax rebates, lowering capital gains taxes, changes to retirement plan tax treatment and estate tax rules.

Following both of these events the municipal market responded with a sharp sell-off within 12-18 months. This equated to approximately 40% underperformance of municipals versus Treasuries in 10-year maturities from levels two years before each presidential election. In other words, ratios move from 100% to 140%. Undoubtedly a major move.

The George W. Bush-era Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) primarily accelerated the tax cuts included in EGTRRA to include the 2003 tax year.

This is where things get interesting…. Following JGTRRA in 2003 and approximately 18 months after the implementation of ERTA by Reagan in 1981, municipal market performance sharply rebounded from the nearly 40% underperformance to around 10% underperformance. Essentially a 30% outperformance in the following years.

The head-scratcher part of this scenario begs the question, “Why would municipals significantly outperform following the expedited lowering of tax rates in 2003?”

To be clear, by no means did we observe, nor do we think going forward that the municipal market will lose its cache with investors seeking to benefit from the tax free status based on changes to tax code. In short, over the next 12-18 months, handicapping municipal bond performance would suggest that 40% underperformance at a given point in time to be the “worst-case” scenario. At this point, with ratios at 97% coming into today, we have already moved off the low ratio in early 2016 of 81%. Therefore a 16% point move has already occurred over the past 11 months. Further weakness would suggest a buying opportunity to get the market back to the 10% underperformance figure we settled into following the Reagan- and Bush-era cuts.

Crossover buyers, low absolute rates, the relative safety and liquidity of municipal debt all have the potential to come into play. We believe there should be ample opportunity for investors to continue to benefit from the advantages of tax-free municipal income going forward. The hurdle for rates to make sense to investors may simply shift higher (and may have already done so).

CRN: 2016-1108-5627R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com.