Bond Market Unlikely to React Strongly to Tax Plan: Analysts

By Allyson Versprille

President Donald Trump’s tax plan is unlikely to trigger a frenzied municipal bond sell-off even if it includes provisions that negatively impact the exempt bond market, analysts told Bloomberg BNA.

Conflicting messages on tax reform from high-level officials in Trump’s administration have desensitized the market, Citigroup Inc. analysts Vikram Rai, Jack Muller and Loretta Bu said in an April 24 note to clients. “Now investors seem to shrug off statements from the administration regarding tax-reform” though they haven’t completely discounted that an overhaul could happen eventually, they said.

Rai told Bloomberg BNA April 25 that investors have begun to realize how difficult it will be to overhaul the tax code, especially with such a divided Congress. “I don’t think we’ll see a very sharp reaction from the bond market or the municipal market,” he said. The opposite would have likely been true had Trump’s tax plan been unveiled six months ago, Rai said.

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Trump is scheduled to release his plan April 26, but it will provide only an outline of a more detailed plan expected in June.

Matt Fabian, a partner at Municipal Market Analytics Inc., agreed that the plan is unlikely to cause huge waves in the municipal bond market.

Achieving comprehensive tax reform before year-end seems less plausible than it did immediately after Trump was elected, he said. There haven’t been any congressional hearings on potential tax reform provisions and no bills have been introduced, Fabian said.

November Sell-Off

Even if some investors sell off their municipal bonds as a result of Trump’s tax announcement, history shows that these types of reactions aren’t always lasting.

“The municipal bond market reacted strongly in November in the aftermath of the election as investors pulled money from the sector, causing yields to rise significantly relative to Treasuries,” Benjamin Streed, a fixed-income strategist at Raymond James Financial Inc., said in an April 25 email. But this sell-off reversed over the last few months, he said.

“The data indicate that investors appear more comfortable with short and intermediate maturities, but overall the initial sell-off might’ve been a bit overdone,” Streed said.

Recent strength in the municipal market may indicate that, while investors seem to know tax reform is still on the docket, they expect the overhaul to be less extreme than initially thought, he said.

For example, during the week ending April 12 municipal bond funds saw inflows of $1.63 billion, according to Thomson Reuters Lipper, Streed said. “This marks the third largest inflow on record and most since 2009,” he said. And “although we haven’t undone the outflows since the election, muni markets are recovering as investors continue to seek out high-quality, income producing, tax-exempt assets.”

Potential Tax Provisions

Expectations of the tax plan are for a “bird’s eye view,” Streed said. “Investors care about specifics. Those specifics, whenever they arrive, will be critical. At this juncture there are likely to be many unknowns in the plan.”

One provision the Trump plan is expected to include is a 15 percent corporate tax rate, which could be an especially divisive issue among lawmakers, Rai said. The deficit hawks in the Republican party “understand that a lower corporate tax rate will increase the cost of tax reform because every 1 percent cut to the corporate tax rate costs the federal government $100 billion” over a decade, he said.

A 15 percent corporate rate would also negatively impact the municipal bond market, if enacted.

Banks and insurance companies are the primary crossover buyers of municipal bonds, Fabian said. Cutting the corporate tax rate to 15 percent would reduce the value of a municipal bond’s tax exemption and the after-tax benefit to those companies, he said.

At the beginning of the tax reform discussions, issuers were concerned that municipal bonds could lose their exemption in order to pay for other parts of the tax plan, but those fears have subsided, the analysts said.

“The risk of tax reform damaging the exemption is relatively low,” Fabian said. “But if we’re wrong, then the potential correction would be harsher because most of the market is expecting the same thing to happen.”

‘Moderate’ Negative Effects

Fabian said while he doesn’t anticipate that the municipal bond market will react strongly to the Trump tax plan, there could be “moderate” negative effects.

“I think it’ll tend to trend negative because investors who have put their money into equities in the belief that tax reform is going to happen are going to be consoled by the president talking more directly about tax reform,” he said.

It will perpetuate the “risk-on” trend—meaning investors engage in higher-risk investments like stocks—that started when Trump took office.

As a result, Treasury bond prices could fall and “munis will tag along” because they trade closely with respect to Treasuries, Fabian said.

Additionally, talks of a tax plan that isn’t deficit-neutral could be a red flag to muni investors. Increasing the deficit would prompt the government to issue more Treasuries in the long term to generate revenue—increasing supply and reducing demand. Adding to the deficit could also jeopardize the U.S. credit rating, he said.

To contact the reporter on this story: Allyson Versprille in Washington at aversprille@bna.com

To contact the editor responsible for this story: Meg Shreve at mshreve@bna.com

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The Citigroup client note is at http://src.bna.com/ofs.

The Week in Public Finance: Ballmer's Data Trove, Grading Pension Health and a New Muni Bond Threat

This Goes Way Beyond Open Data

You might not peg former Microsoft CEO and current owner of the NBA’s Los Angeles Clippers as a government data geek. But Steven Ballmer stepped into that role in a grand scale this week when he unveiled his privately funded, years-long project to help citizens easily track how government spends their money.

Called USAFacts, the website contains federal, state and local aggregated data on revenue and spending, as well as on debt, population, employment and pensions. Want to know about pension debt? Two quick searches reveal that unfunded liabilities in state and local retirement systems have more than quadrupled since 2000. At the same time, the median age in the country has increased by 2.5 years.

As a businessman used to the corporate world, Ballmer wants to make government financial reports more readable. To that end, the site has introduced the first government "10-K report" -- the private sector's version of an annual financial report. It aggregates data from all U.S. governments and gives progress reports on government programs, provides financial balance sheets and gives data on key economic indicators.

The Takeaway: Ballmer says USAFacts is not meant to insinuate that governments should be more like businesses. But the creation of this data trove does speak to a growing desire among the business community and citizens for better access to uniform financial data. No two governments are alike in how they present and deliver their financial data, to say nothing of the amount of time in which it takes them to do so. That makes any data compilation incredibly burdensome. Now, at least on a national basis, that headache has been eliminated.

What's more, shining a light on the real numbers behind government has the potential to change peoples’ assumptions about it. By way of explanation, Ballmer looked up how many people work for government in the U.S. The answer: nearly 24 million. When people hear that, they tend to say, "‘Those damn bureaucrats!’” he told The New York Times. But a look at the data may elicit a different response. Almost half are educators. Active-duty military and health workers represent huge blocks as well. Now, "your tax dollars are helping somehow to pay 24 million people -- and most of these people you like,” Ballmer said.

Diverging Pension Paths

A new report  this week from the Pew Charitable Trusts shows that while a number of public pension plans took positive steps toward solvency, their total unfunded liabilities still increased in each of the last two years. It also found that in 2015, more than half of states achieved what’s called positive “net amortization.”

The metric, introduced by Pew  last year, essentially measures whether a state is on a path to eventually eliminate its unfunded pension liabilities. The measurement does this by looking at whether a pension plan’s accounting assumptions -- notably its assumed investment earnings -- and payment schedule will hold up over time. In 2014, just 15 states achieved positive amortization. The following year, 32 did.

Despite this improvement, unfunded liabilities increased to $1.1 trillion in 2015 and are expected to total $1.3 trillion when data from 2016 is complete. The more than $350 billion increase over two years is largely due to lower-than-expected investment earnings. However, the report notes that roughly $8 billion of the shortfall is due to plans not paying their full pension bill.

The Takeaway: While it’s good that more plans shifted into the positive, there are still things to be wary about. Namely that the shift could be short-lived: There are still legitimate concerns that pension plans won’t meet their assumed rates of investment return. “Obviously you don’t know what the future will hold,” David Draine, a senior researcher, told reporters, “so the question is, are policies in place sufficient to address the uncertainty?”

For 18 states, Pew’s report says the answer to that question is a resounding no. These states have negative net amortization, meaning their liabilities will continue to increase unless they change their funding habits and/or assumptions. These states include Colorado, Illinois, Kentucky, New Jersey and Pennsylvania, which fared worst on this benchmark in 2015.

Muni Tax Exemption Threat Not Over Yet

The tax-exempt status of muni bonds might not be as safe under the current administration as some have thought. Several municipal analysts have been warning that the exemption, which allows muni bond investors to earn tax-free interest on their bonds, could be threatened by tax cuts that disproportionately benefit the wealthy.

In particular, President Trump has proposed major cuts in taxes on investment earnings. Compared to corporate bonds, municipal bonds earn slightly lower interest rates for investors because of their tax-free perk. But Court Street Group analyst George Friedlander has said a significantly lower tax rate capital gains might negate that perk -- and see investors turn more towards taxable debt for the higher investment earnings.

That lower demand for munis would drive up their interest rates and make it more expensive for governments to issue bonds. That introduces the possibility that reformers would argue the exemption therefore doesn't make much of a difference in goverments' borrowing costs. This could be the ammo some need to nix the perk entirely. That, noted Municipal Market Analytics’ Tom Doe this week, could be a boon for public-private-partnerships (P3s), “under the guise of efficiency, savings and jobs for the middle class.”

The Takeaway: Businesses have advocated that P3s offer better procurement, less risk for governments and are an ultimately cheaper way to deliver new infrastructure. But they haven’t taken off in the U.S. primarily because the municipal market offers such relatively inexpensive financing for governments. By comparison, Europe has no municipal market equivalent and P3s are the primary financing mechanism for major projects.

A key player in all this might be the role of Gary Cohn, director of the National Economic Council and a former Goldman Sachs president. As President Trump reshuffles key staff, Doe notes that Cohn, a Democrat, may soon ascend to Trump’s chief of staff. Democrats have supported limiting the tax exemption because it is largely seen as a perk for the wealthy, who are the primary investors in muni bonds. In addition, a Democrat could be more effective in whipping up bipartisan support to push through tax reform. “Trump wants wins now,” Doe wrote, “and Cohn may simply be the guy to deliver.”