However, for many people with hefty state and local tax bills, the new federal tax law gives municipal bonds some appeal. The new law caps the state and local tax deduction that can be claimed on federal returns at $10,000. For many households, that cap will outweigh any potential benefits from other changes in the law.
For these people, tax-free investment income (like muni bonds) becomes quite valuable. Industry experts warn that despite the appeal of municipal bonds, investors need to be careful because the municipal bond market can be complicated.
Other elements of the reform bill, however, could adversely impact longer-term demand for tax-exempt muni bonds. The bill disallowed the common practice of advance refunding, which enabled municipalities to lower their costs by refinancing debt at lower rates.
Hession said that advance refunding had accounted for approximately 15 percent of muni bond issuance over the last 10 years.
“It’s like refinancing a mortgage,” said Hession of Riverbend Capital Advisors. “The bill eliminates the ability of [municipalities] to issue new debt to retire older deals and save money.” With interest rates on the rise, however, these refinancing moves would likely diminish, anyway.
The bigger issue affecting demand for muni bonds is the change in tax rates. With lower marginal tax rates, tax-free income is relatively less valuable. The lowering of the top bracket to 37 percent, from 39.6 percent, may diminish demand slightly in the high-net-worth market segment, but most analysts believe the impact will be muted.
“The need for income hasn’t changed for retail investors and retirees,” said Hayes at BlackRock, which currently manages $129 billion in its muni bond funds. “People also see municipal bonds as a safe investment.”
The changes on the corporate side of the demand equation, however, could have a bigger impact. With the corporate tax rate reduced to 20 percent, down from 35 percent, both Hayes at BlackRock and Hession of Riverbend Capital Advisors expect the banks and insurance companies that make up about 30 percent of the market will now have less interest in tax-free bonds.
“We’ll likely see diminished appetite for tax-free bonds on the institutional side,” said Hession. “There will still be interest in munis from institutions, but this will impact demand.”
Hayes at BlackRock said there is already evidence that banks and insurance companies are reallocating assets from municipal to investment-grade bonds.
One potentially mitigating factor is an increase in demand for munis in high-tax states such as New York and California. Because the tax bill capped the deductibility of state and local income taxes at $10,000 per individual, taxpayers in those states will be looking to maximize other deductions and minimize taxable income. Municipal bonds in those states already have been outperforming the market.