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Written by: Michael Cohick | VanEck
While we remain bullish on the municipal asset class going into 2017 (see Jim's post A Case for Municipal Bond Optimism ), Donald Trump’s upset win over Hillary Clinton in the 2016 election caught many people in the investment community by surprise. We will examine what the aftermath of the 2016 election may portend for municipal bonds going forward.
Background
In the week leading up to the election, the municipal bond market had just emerged from a somewhat turbulent October, owing to greatly elevated supply coming into the marketplace. The excess supply caused muni bond prices to decline, and brought to an end a remarkable 54-month string of net inflows into muni bond-centric vehicles, based on data from Morningstar.
Looking Forward
We see three critical issues that muni bond investors may want to pay attention to in the months ahead as we transition to a Trump administration.
1. Lower Tax Rates on Corporations and Individuals
Much of Trump’s economic platform is concerned with corporate and individual tax reform. He has proposed lowering taxes across the board for individuals and corporations, while also lowering taxes on repatriated earnings to encourage corporations to bring money back from overseas. Perhaps most notably for high net worth individuals, it is proposed the three highest tax brackets — currently 33%, 35%, and 40%, respectively — would be collapsed to a single 33% 1 rate.
Corporations — in particular property and casualty insurance companies — and high net worth individuals are some of the largest purchasers of municipal bonds. One of the most important contributors to muni bonds’ attractiveness to corporations and high net worth individuals is their status as tax-exempt investments. If corporate tax rates fall, this tax-exemption could become less of an attraction for this class of investor in muni bonds.
Such tax rate decreases would likely force a repricing of the municipal bond marketplace in order to keep these investments attractively valued relative to other asset classes. In other words, municipal bond yields would have to rise in order to remain competitive with ordinary taxable bonds. This is not to say that higher yields would necessarily reflect poorer creditworthiness on municipalities’ part.
2. Puerto Rico’s Debt Crisis
It is unclear what exact plans Trump has when it comes to dealing with the Puerto Rico's debt crisis — the island has already defaulted on a portion of the $70 billion in municipal bonds it has issued. 2 The president-elect has previously said 3 that the U.S. government should not bail out the island, and that the commonwealth should instead cut spending. It should be noted that the governor-elect (of Puerto Rico) is not seeking a bailout, however, but instead the legal ability to restructure its debts.
Immediately following election night, some Puerto Rico general obligations rose to new yearly highs on the election of Ricardo Rossello, a New Progressive Party candidate, as governor. Rossello, whose party favors Puerto Rico's statehood, has previously said that bondholders should be paid with interest if they acquiesce to a longer wait for principal payments — in other words, if Puerto Rico’s debt can be restructured. This stance is in sharp contrast to that of the current Puerto Rican administration, which has already defaulted on roughly $1.8 billion in debt service costs in the last year. 4
3. Increased Domestic Infrastructure Spending
Another important factor to consider is Trump’s plan for massive infrastructure spending on new hospitals, roads, airports, railroads, schools, and more, to the tune of $500 billion and up. If such a large spending bill comes to pass, it could mean elevated supply coming online in the muni bond market, as most of these projects typically find financing in the municipal marketplace.
When viewed in the context of proposed across-the-board tax reforms, the potentially huge outlay on infrastructure has led some to speculate that the federal government may end or limit the tax exemption on municipal bonds. Though such a move is technically possible, it is highly improbable. 5 An elimination of the municipal bond tax exemption would likely lead investors to demand higher yields on muni bonds, increasing government borrowing costs.
The Bottom Line
If Trump’s plan to reduce corporate tax rates comes to pass, it will likely force a reevaluation of the municipal bond market, potentially resulting in higher muni bond yields. The president-elect’s plans with regard to Puerto Rico’s debt crisis remain largely unknown, although roughly $70 billion worth of municipal bonds hangs in the balance. On the supply side, massive infrastructure spending would probably be financed in large part through new municipal bond issuance on an expanded scale, increasing supply substantially.
I believe we have a while to wait to see what impact, if any, Trump will have on the municipal bond market, but the picture may come into focus once he actually begins to attempt passing legislation.
IMPORTANT DEFINITIONS AND DISCLOSURES1 Who Benefits From Donald Trump's Tax Plan?2 Puerto Rico’s Slide3 Donald Trump won't bail out Puerto Rico4 Puerto Rico Bonds Rally After Rossello Becomes the Next Governor5 Does a Trump Presidency Put Municipal Bond Tax Exemption At Risk?