U.S. election cycles are sometimes fraught with volatility and large changes. Nearly every sector and industry is affected in a method or one other. Under that framework, investors are forced to grapple with the potential of policy changes, and what they might mean for his or her portfolio. And for one area of the fixed-income market, the changes may very well be big.
One clear advantage of municipal bonds may very well be on the chopping block.
Because the incoming Trump administration looks to lift revenues to offset other ambitious tax plans, municipal bonds’ key tax-exempt status could change, which warrants caution from investors.
TCJA Expansion & Potential Deficits
The 2017 Tax Cuts and Jobs Act (TCJA) was the most important tax code overhaul in over three many years and created massive changes for individual and business taxpayers.
Throughout his campaign, President-elect Trump promised to maintain many of the TCJA’s provisions intact, while adding additional personal tax savings. This has included removing the present $10,000 limit on the state and native tax (SALT) deduction and eliminating taxes on Social Security and tip income. Trump has also floated the concept of removing taxes on extra time pay.
On the company side, Trump has looked into reducing the company tax rate farther from the TCJA’s 21% limit. This has included dropping it right down to 20% for “simplicity” or moving it lower, to fifteen%, for firms that manufacture goods domestically.
The issue is that these tax cuts have serious long-term consequences when it comes to budget deficits. In keeping with the nonpartisan Committee for a Responsible Federal Budget CRFB), Trump’s tax cuts and spending plans would end in an estimated $7.5 trillion deficit over the following decade. Other congressional budget groups and the U.S. Treasury Department have concluded similar deficit evaluation, with Trump’s policies adding potentially between $1.45 trillion and $15.14 trillion to deficits.
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Munis Get a Goal on Their Backs
To make up for the loss in revenue from reducing these taxes and reaffirmations to the TCJA’s provisions, policymakers and President-elect Trump have been various sources — and one in every of them happens to be municipal bonds.
Since 1913, municipal bondholders have enjoyed interest-free Federal income taxes. The thought behind this tax exemption was to assist state and native governments enjoy a lower cost of capital for his or her funding and borrowing needs. This exemption on interest has long been a key feature of municipal bonds, and so they have long been a portfolio holding for a lot of high-net-worth family, insurance, and institutional portfolios.
While the exemption has been nearly as good as gold because the early 1910s, Trump has considered munis and their benefits before.
Throughout the writing of the TCJA in 2017, Congressional Republicans proposed restricting the sale of tax-exempt muni bonds for personal sector projects. This could have impacted the high-yield muni market. While that provision wasn’t included within the bill, they did manage to include provisions that eliminated using pre-refunding municipal bonds. Here, a state or local government would issue a bond to benefit from higher rates to repay the proceeds of a bond already coming due.
Heading into 2025, bipartisan support is growing for muni bonds to lose their tax exemption altogether or to alter what munis could still qualify for Federal tax exemption. All in all, municipal bond tax exemptions are seriously considered a method to raise revenue.
Investor Caution Is Warranted
For municipal bond investors, the concept these bonds could lose their essential selling point is pretty dramatic. If Congress and President-elect Trump do in reality remove the tax exemption, it would change how state and native governments fund their operations, construct infrastructure and, essentially, govern. S&P Global estimates that more states can be forced to issue taxable munis to pay for projects, increasing the burden on taxpayers.
Furthermore, the entire amount of funds the federal government would receive from removing the exemption is just around $40 billion. While not insignificant, it remains to be a rounding error when a possible tens of trillions’ value of budget shortfall.
With that in mind, many pundits are betting that widespread muni exemption stays in place. And even when the exemption is taken away, many pundits estimate that already-issued bonds can be grandfathered in, providing existing tailwinds to their demand amid the shrinking supply.
The truth is, most of the issues that changes to the TCJA and extra tax cuts would create could potentially spur higher taxes down the road. This could cause a big tailwind for municipal bonds and their high after-tax yields.
To that end, caution within the muni sector is warranted. But investors may not want to provide up on their municipal bonds just yet — particularly when munis have enjoyed positive returns within the election calendar 12 months and the next 12 months. The 2 outliers on this chart from AllianceBernstein were the 2007-2008 financial crisis and the ‘taper tantrum.’
Source: AB.com
Municipal Bond ETFs
These funds were chosen based on their exposure to municipal bonds at a low price. They’re sorted by their YTD total return, which ranges from 1.9% to three%. They’ve expense ratios between 0.05% and 0.65% and assets under management between $1.2B and $37B. They’re currently yielding between 2% and three.6%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| FMB | First Trust Managed Municipal ETF | $1.9B | 3% | 3.2% | 0.65% | ETF | Yes |
| MUNI | PIMCO Intermediate Municipal Bond Energetic ETF | $1.47B | 2.7% | 3.6% | 0.35% | ETF | Yes |
| MUB | iShares National Muni Bond ETF | $36.8B | 2.2% | 3.0% | 0.05% | ETF | No |
| VTEB | Vanguard Tax-Exempt Bond ETF | $34B | 2.2% | 3.2% | 0.05% | ETF | No |
| SUB | iShares Short-Term National Muni Bond ETF | $8.7B | 2.1% | 2.12% | 0.07% | ETF | No |
| SHM | SPDR Nuveen Bloomberg Short Term Municipal Bond ETF | $3.9B | 2.1% | 2.2% | 0.20% | ETF | No |
| DFNM | Dimensional National Municipal Bond ETF | $1.23B | 1.9% | 2.2% | 0.19% | ETF | Yes |
For investors, it’s perhaps best to remain the course with munis. A state government’s strong budgets and its own hefty rainy funds make the sector a powerful alternative for fixed-income investors — tax exemption or not. Just keep in mind that changes may very well be brewing, and investors may not wish to bet all the farm on a portfolio of munis just yet. Investors must know more about Trump’s tax policy and what’s in store for the sector.
Bottom Line
Municipal bond’s one key advantage — their tax exemption — is once more getting a tough look from policymakers as budget deficits grow and they appear to fill potential revenue voids. That throws some cold water on the sector. Nonetheless, investors may not want to provide up on munis just yet.