The market for tax-free municipal bonds, a favorite of many Californians seeking decent interest income, faces a rough road after Donald Trump's White House victory.
Bond prices have tumbled over the last two weeks, driving yields up. In part, the market fears that Trump and the GOP-controlled Congress will push tax reform measures that could make munis much less attractive to investors.
A worst-case scenario, now revived, is that Congress could start taxing muni bond interest.
Many analysts say the concerns are overblown. In particular, “the tax exemption is probably the last thing to be touched,” said Matt Fabian, a partner at research firm Municipal Market Analytics in Concord, Mass.
But he and other experts acknowledge that muni bonds might be facing prolonged turmoil because of uncertainty over Trump's plans.
Even if muni tax policies aren’t altered, some investors worry that Trump’s promise to rebuild U.S. infrastructure could flood the market with new bonds, devaluing older bonds. And overlaying all this is the expectation that the Federal Reserve will push interest rates higher if the economy continues to grow.
Investors’ selling of muni bonds after Trump’s victory has driven the market value of the securities down from record highs in the summer to the lowest levels in more than a year.
The share price of the iShares National Muni Bond exchange-traded fund, one of the most popular muni funds, has fallen from $114 in early July to $108.41 as of Friday, a loss of almost 5%.
Though that kind of decline would be considered modest in the stock market, it’s more severe in the muni market because relative safety is a key reason many people own bonds.
Also, more than half the iShares fund’s loss has occurred just since Nov. 7, the day before the election. The 2.7% drop more than wipes out the fund’s current annualized interest return of about 2.2%.
The $3.8-trillion muni bond market has long been a haven for individual investors’ savings because the interest paid isn’t taxed by Uncle Sam. Individual states, including California, often exempt interest on their bonds from state income tax as well. The bonds issued, in turn, typically finance crucial infrastructure projects such as roads, schools and water systems.
The muni market had mostly been sailing along for the last three years as investors poured in. But the market’s strength began to attract short-term-oriented investors who were more interested in quick capital gains than steady bond income, analysts say.
“We’d been waiting for a pullback in this overheated market for months,” said Marilyn Cohen, a muni market investor and head of Envision Capital Management in El Segundo.
In October, the market was hit by a double whammy.
First, a huge supply of new muni bonds were issued as state and local governments rushed to fund projects ahead of what they expected to be a volatile market after the election.
The total of muni bonds issued hit a record $52.5 billion in October, according to Thomson Reuters data. That massive supply caused market indigestion, pushing bond prices down modestly and yields up to entice buyers. Bond yields move in the opposite direction of prices.
At the same time, interest rates were rising on U.S. Treasury securities, the benchmarks for other bonds. Treasury yields increased as investors bet that a resilient U.S. economy would force the Federal Reserve to soon raise its key short-term interest rate for the first time since last December.
Then, Trump’s surprise victory triggered a sudden frenzy of selling in munis and other bonds, pushing yields up sharply.
The average tax-free yield on 10-year high-quality muni bonds rose from a record low 1.3% at the end of August to 1.63% by the end of October, then surged above 2% this week, according to Bank of America Merrill Lynch.
That coincided with a vertiginous drop in the broader bond market. In Treasuries, the 10-year T-note yield ended this week at 2.35%, up from 1.83% at the end of October and up one full percentage point since June. Worldwide, bonds in the last two weeks suffered their worst price declines in 13 years, according to the Bloomberg Barclays Global Aggregate bond index.
Rising yields should attract more investors hungry for interest income, acting as a brake on the upswing. But in the muni market, many potential buyers may be reluctant now because of political risks.
For one, the market faces months of headlines from Washington about tax reform and federal spending as the Trump administration’s policies take shape.
Peter Hayes, head of municipal bonds at money management giant BlackRock Inc. in New York, figures the GOP-controlled Congress has only “a 12- to 15-month window to get things done,” before the 2018 mid-term election season. One key question will be how to pay for spending that President-elect Trump has pledged while at the same time cutting taxes.
In a July report, the Tax Foundation — a think-tank that has long championed simplifying the tax code — called for Congress to consider ending the tax exemption for muni bond interest. The group says the exemption is “inefficient” tax policy and will cost the federal government $617 billion in forgone tax revenue over the next 10 years.
Muni proponents, however, argue that the market can play a key role in fulfilling Trump’s promise to boost infrastructure spending. “If you want to pump up infrastructure spending you don’t tear down the base” of the muni market, said John Miller, co-head of fixed income at Nuveen Asset Management in Chicago.
But investors also fear that Trump’s spending plans could lead to a glut of new muni bonds hitting the market in 2017 and beyond, driving all muni yields up as issuers struggle to find buyers.
There are, however, other ways to finance some infrastructure spending. Trump has talked about giving tax credits to private investors that contribute project funding in partnership with government entities.
In any case, many experts believe that even if the muni-bond tax exemption were curtailed, existing bonds would be grandfathered.
Another potential tax risk to munis is the GOP policy goal of cutting marginal tax rates. Trump has proposed reducing the top personal tax rate to 33% from 39.6%. In theory, at least, any tax cut would make tax-free muni interest less valuable to investors – which could force muni issuers to pay higher yields to lure investors.
Yet since 1982 the top federal tax rate has changed eight times, up and down, without resulting in lasting shifts in the yields muni investors demand compared with yields on taxable bonds, according to David Hammer, head of muni bond management at fund firm Pimco in Newport Beach.
The bigger picture for muni yields is what’s happening with interest rates in general, of course. If the Fed continues to raise short-term interest rates in 2017, that could lift all longer-term yields as well, including muni yields.
But Hammer makes the case that the jump in yields on munis and other bonds since September has already priced in much of the possible bad news ahead. “The markets have quickly priced in a shift in [government] policy, but actual policy execution will likely unfold over multiple years,” Hammer said in a report to clients this week.
And if the economy slows in 2017, it could pull interest rates down across the board if investors rush back to the relative safety of bonds.
That’s an argument for investors to start hunting now for possible muni bond bargains, comparing tax-free muni yields with taxable yields on Treasury issues and corporate bonds.
Analysts note that the muni market has experienced periodic sell-offs over the last two decades, and that times of turmoil often generate the best opportunities. The previous steep muni decline occurred in 2013, when the Federal Reserve was cutting back on some of its stimulus programs. That gave way to another rally in bond values in 2014 as yields fell again.
But market pros also warn that the current muni slump may not have run its course. The pattern in the market often is that professional investors initiate sell-offs, and small investors who own muni bonds via mutual funds follow weeks later by cashing out some or all of their holdings.
That could fuel another slide in bond values ahead.
“The biggest risk now is that a lot of investors react with a lag,” said BlackRock’s Hayes.