Tax Reform — Real Risk or Fake News?
We have all heard the old market adage: buy the rumor, sell the news. Easier said than done. These days, we have trouble discerning whether the news is even real. The Municipal market has been fixated on the risk of tax reform since Election Day. This fear led to a poor Q4-2016 performance quarter for Municipals. Although the market’s tone this year is much improved with stable asset flows, declining new issuance, and lower volatility, the fear persists.
Since the financial crisis, it has become common for the atypical to become more typical. During the first quarter, it happened again. Conventional wisdom tells us that during a Fed tightening cycle, rates should rise. In the first quarter, Municipal yields actually fell in all but the longest maturities. Five and ten-year maturity yields fell 20 bps and 5 bps, respectively. Long maturity yields ticked up 5 bps. Conventional wisdom also tells us that during a Fed tightening cycle, the yield curve should flatten. In the first quarter, the yield curve steepened. The slope between five- and fifteen-year maturities increased 25 bps. What makes these moves even more unusual was that as we entered 2017, market consensus did not anticipate a rate hike until mid-year. It wasn’t until two weeks prior to the meeting that market expectations changed.
Although investors have yet to fully price in two more rate hikes this year, we view the balance of risk as pointing to a more aggressive Fed policy stance. Our economy has now generated seven consecutive years of growth with core inflation near the Fed’s target of 2% and a national unemployment rate well under 5%. Even in the absence of new fiscal stimulus and the potential for protectionist-leaning trade reforms, we find it difficult to understand how the Fed justifies a crisis-type policy stance. We are pleased that the Fed has appeared to accelerate its pace of policy normalization and that public references to Fed balance sheet reduction have picked up.
Despite an earlier-than-expected Fed rate hike, depressed bond prices rebounded sharply with returns for both intermediate and full maturity benchmarks around 1.6%. We were pleased with our portfolios absolute returns for the quarter, but our relative results were mixed. The largest detractor was the steepening of the yield curve. As we have communicated in prior commentaries, our yield curve position results from individual security values we find, not from a rate forecast. We continue to emphasize floating rate securities at the front end of the curve for their attractive valuations compared to traditional short maturity fixed rate bonds. We remain confident that these bonds will add to performance over the longer run, but recognize that during periods like this year’s first quarter, they may subtract. Beyond this, portfolios in which we have the most credit flexibility, moderately bested others. The extra yield of our less-constrained portfolios helped offset some of the underperformance generated by the yield curve.
Since November’s presidential election, many Muni investors have been on edge about tax reform risk. The recent failure to enact healthcare reform may likely strengthen the Republicans resolve to lower taxes. Municipal bonds are still tax-exempt, but there have been growing concerns about the value of their tax-advantaged income.
We are frequently asked if the market is at risk of a major sell-off in the event of tax reform. We cannot answer the question without first considering market valuations. Fears of reform may have intensified, but they are not new. In fact, the Obama administration had toyed with the idea of limiting the value of the Municipal bond interest exclusion to 28%. Top-rated Municipals often trade at a lower yield than Treasuries because Municipals offer federally-tax-free income. Theoretically, with the top marginal Federal income tax rate of 40%, if Muni yields were 60% of that of comparable maturity Treasuries, they would offer the same after-tax yield. Since Treasuries possess higher quality, better liquidity, and do not face the risk of tax reform, Muni yield ratios are typically higher than what their tax-value would imply. Long maturities rarely reflect the full tax value, while shorter maturities are more efficient. Since the Financial Crisis, long maturity Muni ratios have frequently exceeded 90%- 95%. Municipals trading near their tax value (a low ratio) have much more downside risk should personal and/or corporate income tax rates be reduced. Today’s elevated ratios should quell that concern, but not eliminate it altogether.
Today, we are facing the potentially larger issue of a possible tax rate cut on investment income. Theoretically, as tax rates on investment income decline, Municipals would have a more difficult time competing with taxable bonds, such as corporates, and Muni yields would need to adjust upwardly. Our handy ratio tool comes into play here, as well. In the accompanying graph, you can see the historic Municipal-to-Corporate yield ratio. In this ratio, we use top-rated 10- year maturity Municipal yields adjusted for the prevailing top marginal Federal income tax rate, and for Corporates we use a fifty-fifty blend of single-A and triple-B index yields.
Municipal yields reached historic lows just after Brexit, with the 10-year reaching 1.29%. From the graph, you can see that, compared to corporates, tax-adjusted Muni yields were also quite low. All yields increased post-election and Municipals underperformed dramatically, particularly versus corporates as ratios climbed nearly 50%. We ended the quarter with Municipal ratios modestly below their recent peak. Again, we conclude that current market valuations reflect a significant probability of successful tax reform.
This leads us to the next consideration – how can prospective tax cuts be funded? One could simply assume that the economy grows faster and the cuts will pay for themselves –so called supply side economics. One could assume that deficits will rise and that the cost will be picked by Treasury bond issuance. This option is unlikely to be acceptable to the same fiscal conservatives who helped derail healthcare reform. Option three may be the most realistic – find offsets for the tax cuts to achieve revenue neutrality.
Frequently, offsets can be found in the Government’s lengthy list of tax expenditures. Tax expenditures are forgone tax revenues for the Government and they essentially represent an opportunity cost in the tax code. There are five forms of tax expenditures:
- Deductions – such as the mortgage interest deduction
- Credits – such as the child tax credit
- Preferential Rates – such as the lower rate on long-term capital gains
- Exclusions – such as on Municipal bond income (our personal favorite, of course)
- Deferral of Liability – such as income from controlled foreign corporations
Finding offsets for potential tax cuts has raised additional concerns among Municipal bond investors. Could Municipal bonds lose their tax-exempt status? Before opining on this question, let’s look at the Government’s largest tax expenditures. Topping the list are the usual suspects – exclusion from income of employer-provided healthcare benefits, lower rates on capital gains, the deductibility of mortgage interest, and pre-tax contributions to retirement accounts. The Municipal bond interest exclusion ranks 13th, accounting for less than 4% of the aggregate value of the top-15.
While all options will likely be on the table, the value of eliminating or capping the Municipal interest exclusion is modest. Should either happen, however, the funding of State and local governments would likely become much more difficult or even cascade into turmoil. We all remember the sizable yield penalties that even large, high-quality issuers endured during the Build America Bond program. The penalties for smaller, lower-quality issuers going forward would be far worse. These issuers would likely have to recapture these higher funding costs via higher taxes and fees, which would run counter to a broad economic stimulus plan. Lastly, one of the Administration’s goals is to implement a major infrastructure spending plan, upwards of $1 trillion. To us, it would be illogical to introduce funding difficulties to States and local governments, who would likely be partners with the Federal Government for a major infrastructure program. In summary, we understand investors’ fears, but we view the risk here as low.
We will only know in hindsight whether tax reform was real or fake news. The risk of it is certainly real. Of more interest to us is whether markets have appropriately discounted it. As of this writing we view much of the Municipal downside risk as priced in for intermediate and long maturities. Most of the pain came right after the election. As with any important legislation, and especially with potential national tax reform, the temptation to speculate is real. However enticing that temptation might be, we only focus on what we can control — our credit and valuation work. Forecasting macro events such as tax reform is difficult and makes for better TV than investment results, which is why we remain patiently focused on purchasing durable and undervalued securities. Should markets overreact, we will be prepared to capitalize upon it.
We thank you for your ongoing trust and confidence.
Gregory S. Steier