Federal Tax Proposals and the Municipal Bond Market

Transcription

1 MUNICIPAL COMMENTARY November 15, 2017 U.S. MUNICIPAL BOND MARKET Federal Tax Proposals and the Municipal Bond Market History of the Threat to the Municipal Bond Tax Exemption In recent decades, a number of attempts to limit or eliminate the exemption of municipal bond interest from federal income tax have surfaced and mostly failed. There have also been efforts from issuer groups in support of the tax exemption. Those efforts typically describe the positive impact the financing tool has in supporting infrastructure investment and in enhancing the public good. In 1986 U.S. Senator Bob Packwood (R-OR) and chairman of the U.S. Senate Finance Committee proposed to eliminate the municipal bond tax exemption. The recommendation thrust the municipal market into a short-term frenzy. However, the proposal was later rejected by the entire committee. The Tax Reform Act of 1986 subjected the previously exempt interest on certain private activity bonds to alternative minimum tax (AMT) treatment, a slight but minimal tax benefit change. The Anthony Commission 1989 Report: Wooten Epes, former president of the Arkansas Development Finance Authority, brought to the attention of then Arkansas Governor Bill Clinton that further changes to the tax code would drastically affect municipal bond issuers costs of funds. Mr. Clinton convinced Congressman Beryl Anthony, Jr. to make the case for municipals. In October 1989 the Anthony Commission on Public Finance presented a study titled Preserving the Federal-State-Local Partnership: The Role of Tax-Exempt Financing. The commission s report concluded: The ability of state and local governments to finance the projects needed by their citizens is more critical than ever to economic growth and the health and welfare of our citizens. Flat tax proposals emerged that would eliminate the value of the tax exemption. In December 2010 a report by the Presidential Commission on Fiscal Responsibility and Reform (Simpson Bowles), as part of a comprehensive tax reform proposal, included elimination of the tax exemption of interest from future bond issuance. In April 2012 Senator Max Baucus (D-MT) and a former chairman of the U.S. Senate Finance Committee warned state and local governments during a committee hearing, For every dollar we spend on infrastructure through a tax-exempt bond, 20 cents goes to tax breaks for higher-income taxpayers. The Obama administration regularly proposed to limit the tax-exempt benefit to 28%. Tom Kozlik thomas.kozlik@pnc.com In recent weeks, federal lawmakers have offered up tax plans that would help curtail some issuers ability to sell tax-exempt bonds. Recent Federal Tax Plan Proposals Since 2010 I have been writing about an increasing threat to the municipal bond tax exemption. This opinion was mostly based on the rising U.S. debt-to-gdp ratio and the need for deficit reduction. Municipals faced a threat just before the fiscal cliff but dodged a bullet. In recent weeks, federal lawmakers have offered up tax plans that would help curtail some issuers ability to sell tax-exempt bonds. Under even the most optimistic case, there will be a decline of municipal bond issuance in the first three to four months of 2018 even if the proposed reforms (to municipals) do not pass. If they do pass, tax-exempt issuance could almost be cut in half. Some issuers would only be able to sell taxable debt, which is more expensive, and municipal issuers would not be able to use an advance refunding strategy with tax-exempt bonds. Please see analyst certification and important disclosures on page 5.

2 MUNICIPAL COMMENTARY 2 House Republicans released their anticipated proposed Tax Cuts and Jobs Act bill on Thursday, November 2, The anti-municipal market provisions were unanticipated and were as follows: Terminates private activity bonds (includes 501(c)3 organizations such as hospitals, universities) with an effective date for bonds issued after December 31, 2017; Repeal of advance refunding authority with an effective date for bonds issued after December 31, 2017; Repeal of tax-credit bonds such as Qualified Zone Academy bonds with an effective date for bonds issued after December 31, 2017; No tax-exempt bonds for professional sports stadiums, with an effective date as of the introduction of the bill (November, 2016); Repeal of the individual and corporate AMT; Restrictions that could make municipal bonds less attractive for purchase by insurance companies; Corporate taxes possibly reduced to 20%; and Individuals would not be able to deduct state and local income and sales taxes, effective date as of January 1, Property taxes would remain deductible but would be capped at $10,000 a year. The good news is the proposed bill preserves the tax-exempt status of some municipal bonds. However, the first two bullet points above equal about 40% of all tax exempt bond issuance. And because the effective date is for bonds issued after December 31, 2017, that means there are scenarios we envision where no tax-exempt advance refunding or private activity bonds are sold for the first three to four months, or perhaps maybe not at all in 2018 if there is not conclusion about tax reform. House Republicans released their anticipated proposed Tax Cuts and Jobs Act bill on Thursday, November 2, The good news is the proposed bill preserves the tax-exempt status of some municipal bonds. Overall the implications for many public policy goals are skewed negative especially for concepts such as housing affordability, access to higher education, and effective and efficient delivery of health care. Financial control and flexibility at the state and local levels will be reduced. Municipal bond issuers are likely to pass on higher financing costs to taxpayers and users. We look at the sector-by-sector impact if a tax plan such as the one proposed by House Republicans would take effect. State Government Some, especially high tax states, will be even more resistant to raising future taxes because of the proposal to reduce the deductibility of state and local taxes (SALT). We recently published a report indicating that state government credit quality has been declining at a historical pace, rising pension costs a partial cause, and the impact from the federal proposals do nothing to aid U.S. states. Lawmakers could come under amplified scrutiny because of increased financial pressure on local government, 501(C)3, infrastructure, and other private activity bond issuers. There is a mildly negative bias for credit quality here mostly related the SALT proposal. The proposed elimination of private activity bonds (PABs) indirectly affects state governments. However, the first two bullet points above equal about 40% of all tax exempt bond issuance. Local Government and School Districts The increased tax burden from the SALT proposal and the fact that property values could be negatively affected over time because of the reduced value of mortgage interest are important for local governments. These two factors could have an important negative impact on credit, even for those highly rated entities. Standard & Poor s wrote that this confluence [from SALT and mortgage interest] could hit some AAA rated municipalities especially hard, possibly pressuring some ratings. The ability to no longer realize cost savings from advance refundings reduces financial flexibility. And the elimination of PABs indirectly affects local governments across the board.

3 MUNICIPAL COMMENTARY 3 Charter Schools Momentum of the charter school movement could be dampened. Most charter school issuance is not treated as governmental bonds. Charter schools and other smaller issuers would not be locked out of the capital markets, but interest costs would rise if they had to sell taxable bonds. I do not see a significant credit impact on existing charters, but increased costs could be a barrier to new projects and the momentum of the charter school movement. Momentum of the charter school movement could be dampened. Health Care Affordability is a common theme for most nonprofits, especially in the health care sector. Demographics and rising costs are pressuring even the most efficient providers. The proposed legislation does nothing to relieve these pressures. In fact, it is little known that 501(c)3 bonds, like health care bonds, would be negatively affected by the House s proposal. The elimination of the authorization to issue PABs would raise costs for 501(C)3 health care providers, and no providers would be able to advance refund with tax-exempt bonds. Health care credit could be somewhat pressured in the near to medium term because of rising costs and reduced financial flexibility. Higher Education Costs for private and public higher education institutions would rise across the board. It is also little known that 501(c)3 bonds, like private higher-education care bonds, would be affected by the House s proposal. Private higher education institutions would not be able to sell tax-exempt bonds under the House proposal, and public universities and colleges would not be about to advance refund bonds. The proposed 1.4% endowment earnings tax would hit public and private universities with endowments with values that are at least $100,000 per student. Moody s Investors Service indicated in a sector report that many recent legislative and budget proposals would cut, limit, or add uncertainty to funding for programs that the higher education sector relies on for revenue. The credit impact overall would be moderately negative for some and negative for others. College tuition affordability could also be negatively affected because of the elimination of the ability to deduct student loan mortgage interest, limit of tax credits, and the limitation or reduced value of other deductions. Housing Affordability in housing was discussed as a key theme during a panel at the Moody s 2017 Public Finance conference in November Most of the discussion revolved around how difficult affordability was for many high population U.S. areas in the current economic environment. State housing finance agencies (HFA) typically offer loans to low-income and first-time home buyers. The proposed plan by the House Republicans would eliminate tax-exempt borrowing by housing issuers. The value of low-income housing tax credits would be reduced generally because of the proposed corporate tax rate cut from 35% to 20%. Also, in effect, the proposal would completely eliminate the use of the 4% low income housing tax credit because the 4% credit can only be used when 50% or more of the project is funded when using tax-exempt PABs. This proposal would also reduce the construction and preservation of affordable housing in the near to immediate term. State HFA credit quality could be negatively affected over time. The elimination of the authorization to issue PABs would raise costs for 501(C)3 health care providers, and no providers would be able to advance refund with tax-exempt bonds. The proposed plan by the House Republicans would eliminate tax-exempt borrowing by housing issuers. Transportation Sectors D+ is the grade the United States earned on the 2017 Infrastructure Report Card assigned by the American Society of Civil Engineers. Infrastructure spending is an issue that President Donald Trump ran on during his 2016 campaign. But the House proposal has major, mostly negative, implications for the future of the transportation sector. Eliminating PABs will probably curtail investment in airports, ports, road, and surface transportation in the near to immediate term. Many projects may not work at all depending upon the breakeven. Higher costs will be passed on to taxpayers and users. The elimination of other transportation and commuter credits could also affect usage. We expect higher costs and credit pressure will build over time.

4 MUNICIPAL COMMENTARY 4 Alternatives to Tax-Exempt Bonds Issuers would be able to sell taxable bonds in most situations. The problem is they are more expensive and the cost will rise relative to the current market as interest rates rise. As alternatives to bonds, there is also the potential for issuers to use bank product solutions. Derivatives or interest rate swaps could also be employed. It would make sense for some issuers to lock in forward rates with derivatives when appropriate. It is also possible that the use of synthetic advance refundings are structured by using fixed payer swaptions. It is quite possible that municipal entities begin to use these types of strategies more often. Impact on Tax-Exempt Bond Buyers Banks and insurance companies have become more prevalent buyers of tax-exempt bonds in recent decades. In many cases, their increased buying participation has helped offset the decreased retail bid. A lower corporate tax rate could reduce buyer interest, and this reduced buyer interest could lead to higher tax-exempt rates that will be needed to lure additional buyers into the market. However, this equilibrium will need to be tested in an environment where almost half of issuance could be removed from overall supply. Outlook on Supply I always expected we would see sub-$300 billion issuance before we saw issuance over $500 billion annually. But I thought it was going to be a result of rising rates, not political risk from Washington lawmakers. But the result could be the same. Taxable issuance will increase in almost any scenario. The supply of tax-exempt issuance will be less. We will need to see how the next few weeks or months play out before we put a number on it and adjust our 2018 forecast. Senate Version, Some Differences The Senate version of the Tax Cuts and Jobs Act was released a week later, the evening of Thursday, November 9, The meaningful difference between the House version is that the elimination of PABs was not included. A similarity is that the repeal of advance refundings is included so that important financing tool remains on the chopping block. This does not mean that PAB issuance is out of the woods. Let me explain why, as we consider three potential scenarios. Municipal Focus: How Could This All Play Out Over the Next Few Weeks or Months? Scenario #1: Quick Agreement on the Tax Cuts by the end of % possibility. Let s assume there is a quick consensus on the majority of the proposals in a form that looks closer to the Senate version. For the sake of being conservative and more politically realistic, let us also assume the portion that repeals advance refundings is included, but not the portion terminating PABs. Immediate market impact: Issuers in 2018 and beyond are no longer able to advance refund with tax-exempt bonds. This removes an important tool from municipal issuers financial toolbox at a time when budgets are tight and credit quality has already been deteriorating at an unprecedented pace, considering we are multiple years into an economic recovery. Scenario #2: No Time for an Agreement in 2017, but Small Tax Cut Package Agreed Upon in March % possibility. Lawmakers really do not have all that much time left this year, especially when you consider their focus will quickly shift to a December 8 deadline related to the federal budget. Therefore, it is quite possible that lawmakers leave Washington by the end of 2017 without a tax reform deal but take up the cause in the second session of the 115th Congress in January I think the debate will then last until the end of March. The result could be a legislative package that centers on tax cuts, but not cuts at the extraordinary level that requires municipal bond market pain. That would likely mean that both PABs and advance refundings are off the chopping block. Immediate market impact: Issuers are not able to sell advance refunding A lower corporate tax rate could reduce buyer interest, and this reduced buyer interest could lead to higher tax-exempt rates that will be needed to lure additional buyers into the market. The meaningful difference between the House version is that the elimination of PABs was not included. Lawmakers really do not have all that much time left this year, especially when you consider their focus will quickly shift to a December 8 deadline related to the federal budget.

5 MUNICIPAL COMMENTARY 5 or PAB bonds in first-quarter 2018 but can sell them after the tax package is final and those municipal components are safely off the chopping block. Scenario #3: Uncertainty for All During % possibility. What if there is no consensus in 2017? What if lawmakers cannot find a compromise by the end of March 2018? Then lawmaker attention could turn to the federal budget process and they would most likely become focused on the 2018 mid-term elections. Even worse, what if the tax reform proposals are still out there with a potential effective date of December 31, 2017? Immediate market impact: Issuers are not able to sell advance refundings or PABs all year, despite the fact that there has been no action on the tax reform proposals. What happens beyond 2018 is uncertain. Support for the Tax Exemption and its Components One thing the recent attacks on the municipal bond tax exemption has done is jump-start organization and issuer support for the municipal bond tax exemption and its components. Behind-the-scenes lobbying and education efforts by individuals and organizations have been strong since just before the fiscal cliff, so it is not like those groups were completely blindsided and unprepared. Also, those efforts have been re-energized. But the timing does not work to their advantage. It is likely this is only the next chapter in the book on treating the municipal bond tax exemption. Remember, at some point lawmakers will revisit and become serious about deficit reduction. Then the municipal bond tax exemption and what is left of its components could again be put on the chopping block. One thing the recent attacks on the municipal bond tax exemption has done is jump-start organization and issuer support for the municipal bond tax exemption and its components. Then the municipal bond tax exemption and what is left of its components could again be put on the chopping block. This material is not considered research and is not a product of any research department. The author of this material is a Municipal Market Strategist whose compensation is not directly based on the success of any particular transaction or transactions. PNC Capital Markets LLC ( PNCCM ) may trade the securities/instruments that are the subject of/mentioned in this material for its own account for resale to clients and, as a result, may have an ownership interest in these financial instruments. The author may have consulted with the trading desk while preparing this material, and the trading desk may have purchased or sold the financial instruments that are the subject of this material prior to publication. This material is informational only and is not intended as an offer or a solicitation to buy or sell any security/instrument or to participate in any trading strategy. This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. PNCCM believes the information contained herein to be reliable and accurate; however, neither PNCCM nor its affiliates make any guaranty or warranty as to its reliability or accuracy. PNCCM is not providing investment, legal, tax, financial, accounting or other advice to you or any other party. PNCCM is not acting as an advisor or fiduciary in any respect in connection with providing this information, and no information or material contained herein is to be construed as either projections or predictions. Past performance is not indicative of future results. PNCCM, member FINRA and SIPC, is a wholly owned subsidiary of The PNC Financial Services Group, Inc. ( PNC ) and affiliate of PNC Bank, National Association ( PNC Bank ). PNCCM is not a bank or a thrift, it is a separate and distinct corporate entity from its bank affiliate. Investment banking and capital markets activities are conducted by PNC through its subsidiaries PNC Bank and PNCCM. Services such as public finance investment banking, securities underwriting, and securities sales and trading are provided by PNCCM. Retail brokerage services and managed account advisory services are offered by PNC Investments LLC, a registered broker-dealer and a registered investment adviser and member of FINRA and SIPC. Annuities and other insurance products are provided through PNC Insurance Services, LLC. Important Investments Information: Brokerage and insurance products are: Not FDIC Insured Not Bank Guaranteed Not A Deposit Not Insured By Any Federal Government Agency May Lose Value 2017 The PNC Financial Services Group, Inc. All rights reserved. pnc.com