October 29, 2020
If a single investment stands to be most affected by the outcome of the US election, arguably it would be municipal bonds. While the market dislocation triggered by COVID-19 and the low interest rate environment are clearly factors affecting municipal bonds, the election may have tax policy and legislative ramifications for the asset class.
Of course, it matters who wins the presidency. But perhaps more important is whether the election leaves the two houses of Congress split between Republicans and Democrats or the opposing party to the president controls both the House and the Senate. Those two scenarios would likely result in a continuation of the status quo. A sweep by one party – particularly a “blue sweep” where Democrats gain control of the White House and Congress – would likely result in more tax-related and policy changes.
Impact on provisions that touch munis
In a blue sweep, we would expect a certain amount of rollback of the Trump administration’s 2017 tax cuts. While exact proposals are not available, it seems likely that the rollback would include both the corporate tax rate and the top brackets of the individual tax rate. Other key provisions with potential implications for municipal bonds, which may be affected by either side winning and are discussed in more detail below, include:
- state and local taxes (SALT) provision
- the alternative minimum tax (AMT)
- advance refunding.
A switch in SALT?
Because municipal bonds’ value proposition is their tax preference, and lower tax rates tend to diminish this value, the tax cuts that went into effect in 2018 -- including moving the top rate for individuals down from 39.6% to 37% -- were considered a negative for munis. But the tax law had an unexpected wrinkle, especially for higher bracket taxpayers: a new cap on state and local tax (SALT) deductions. Starting in 2018, the maximum SALT deduction was $10,000, whereas previously there was no limit. So while some higher-income filers had a lower marginal income tax rate, the cap on SALT deductions could leave them with a higher adjusted gross income, and a higher tax bill. In addition, wealthy residents of wealthy states tend to pay relatively significant state and local taxes.1
If the tax cuts are rolled back following a congressional Democratic sweep, we believe there could be enough seniority and power from large Democratic states such as New York, Illinois, and California to encourage the repeal of the SALT provision as well.
AMT: Here today, gone tomorrow?
If President Trump wins re-election, we anticipate an end to the alternative minimum tax (AMT), which recalculates income tax after adding back certain tax preference items. AMT has already been eliminated for corporations, and the 2017 tax law began phasing it out for taxpayers, with the president making public commitments to eliminate it for individuals.
In our view, a Democratic win would likely result in a return to original AMT calculations on top of potentially higher income taxes and no SALT provision. This could affect investors’ decisions to invest in municipals. Policy changes on AMT also affect the spread between AMT and non-AMT paper, which tends to tighten when fewer investors are subject to AMT and widen when more investors must pay the tax.
Future for infrastructure
Infrastructure, such as roads, bridges, and airports, is one area that both political sides seem to agree on but nonetheless have found difficult to fund, resulting in decades of underinvestment. US infrastructure received a grade of D+ from the American Society of Civil Engineers (ASCE) most recently in 2017, with similar ratings since 2001 (source: ASCE). The Trump administration did not move forward with an infrastructure plan in its first term. Democratic proposals would indicate significant infrastructure funding, but one question is how much it would be tempered by pandemic stimulus spending.
Historically, most of the financed portion of infrastructure spending (roughly 75%) has been executed through the municipal bond markets. But with many state and local governments already feeling financial stress from the pandemic, this may affect their ability to take on at least a portion of infrastructure projects.
It’s difficult to know the impact of the election, but in our view, the prospects for an infrastructure package increase dramatically with a blue sweep. If it comes to pass, we would likely see a program similar to the Build America Bonds (BAB) program of 2009, although probably not as subsidized as the 35% interest subsidy that BAB offered from the federal government to offset the cost of issuing debt.
Advance refunding back in play?
Prior to the 2017 tax law, advance refunding bonds could be issued on a tax-exempt basis, saving states, local governments, and other eligible issuers significant financing costs. The Trump tax law eradicated advance refunding. But while this had an impact on the tax-exempt municipal market, a 2018 IRS ruling, which allowed advance refundings for tax-exempt issues refunded by taxable municipals (if economically feasible), helped to stage a strong showing for the taxable part of the market. We are currently seeing a significant uptick in taxable supply, with taxable municipals up 227% in the third quarter alone (source: Bond Buyer). If the tax law is changed to again allow advance refunding by tax-exempts under the prior system, it would reshift the marketplace for both tax-exempt and taxable municipals.
Net election effects
The overall environment for the municipal market continues to be subject to forces such as the continuation of COVID-19 and the low interest rate environment. But the US election could portend changes in tax policy that would affect municipal bond investing. All things considered, we see potential changes stemming from the election that could provide a boost in municipal demand.
1 According to the Tax Foundation, those with incomes greater than $100,000 have been shown to receive more than 88% of SALT deduction benefits.