These tax-free assets face ‘most important election’ in a long time
Next week’s presidential election could have a big impact on municipal bonds, according to Morgan Stanley. Potential changes in tax policy could sway muni demand, depending on whether former President Donald Trump or Vice President Kamala Harris wins. The interest earned from the bonds are exempt from federal tax and may also be free of state tax if the investor resides in the issuing state. “This is probably the most important election we have seen in a really long time as far as impact on the muni market,” said Craig Brandon, co-head of municipals at Morgan Stanley. Looming large is the expiration at the end of 2025 of provisions in the Tax Cuts and Jobs Act of 2017 . Many of these will affect municipals, he noted. Among the provisions set to expire without Congressional intervention are the lowered federal income tax brackets, a $10,000 cap on state and local tax deductions (SALT) and increased alternative minimum tax (AMT) exemption amounts. While the 21% corporate tax rate was a permanent provision of the TCJA, Harris has called for raising it back to 28% . In addition, parts of the muni market may be affected by the policies of the next administration, according to Nuveen. Tax implications and demand If the lowered tax brackets sunset at the end of 2025, the highest tax bracket will revert back to 39.6% from 37%. In that case, the federal tax exemption becomes worth more, said Dan Close, head of municipals at Nuveen. For instance, a muni bond yielding 5% has a taxable equivalent yield around 7.9% under the current tax 37% rate, he said. With the 39.6% tax, the taxable equivalent yield goes to 8.25% for taxpers in the highest bracket, he calculated. However, studies have shown a move of just a couple percentage points “doesn’t really move the needle” for muni demand, Brandon said. “If you have a major change in rates it could impact the demand for munis,” he said. Meanwhile, changes to the AMT could be very meaningful for muni investors, Brandon said. “I don’t think people realize that there is a pretty large part of the muni market where the coupon is exempt from ordinary income, but it is not exempt from the AMT,” he said. One such area is airport bonds, he added. The TCJA increased the AMT exemption and raised the income level at which the exemption would phase out. In 2017, prior to when the law took effect, the exemption was $54,300 for single filers and $84,500 for those married filing jointly. The exemption phaseout threshold was $120,700 for single filers and $160,900 for married taxpayers filing jointly. In 2025, the exemption amount for single taxpayers is $88,100 and $137,000 for married couples filing jointly, according to the IRS. It begins to phase out at $626,350 for single filers and $1,252,700 for married taxpayers. “There are not many people left paying AMT now,” Brandon said. What that means is investors who are not paying AMT but are buying AMT bonds in the 10- to 12-year space are getting about 50 to 55 extra basis points of yield, the MOrgan Stanley analyst explained. One basis point equals 0.01% “That is why there is so much depending on what they do with the AMT,” he said. “If the AMT comes back to where it was under a Harris administration, that will impact demand for those bonds. People may not want those bonds.” Less demand will cause spreads to widen, he added. If Trump wins and makes the AMT changes permanent, “that is 55 basis points of free income and that yield could compress and they could outperform the market,” Brandon predicted. Lastly, the corporate tax rate could also alter the muni landscape. That’s because banks and insurance companies in the U.S. own about a quarter of all outstanding muni bonds, he explained. When the corporate rate was 35%, banks and insurance companies owned a lot of municipal bonds, but when it fell to 21% on an after-tax basis, munis became less attractive and they bought more corporate bonds. If the corporate tax rate rises to 28%, that would cause more demand for munis, he said. At the margin at least, those banks and insurers would sell their corporate bonds and ramp up their muni allocations, he added. Sector impact Nuveen anticipates some muni sectors will be most affected by different policies, although it doesn’t anticipate a meaningful impact in most sectors. Within health care, a Republican sweep could mean an easier path for hospital mergers and acquisitions, but challenges for hospital profitability. More than half of health-care revenues are determined by Medicare and Medicaid reimbursement rates, Nuveen’s Close said. “We think that there is going to be a lot of privatization or a greater potential for insurers playing a larger role in administering Medicare and Medicaid,” he said. “It means less negotiating power and lower reimbursement, potentially.” A Democratic sweep would mean less possibility of mergers, he said. When it comes to education, most of the funding is at a state and local level, but the federal government does have some ability to influence the sector, Close noted. A Republican sweep would likely result in more money going to support charter schools and less to public K-12 programs, he said. There is also a higher probability of some taxes on endowments for institutions that have been in the crosshairs of Republicans, which could be a potential headwind for credit, he added. There is also a lower probability of student loan forgiveness — or even a rollback of student loan forgiveness, and with it a headwind for higher education, he said. A Democratic sweep would be more positive for education muni bonds because there would be an increased likelihood of greater student loan forgiveness, additional funding for community colleges and generally more spending for K-12 schools, Close said. Finally, ports could get hit if tariffs are increased and lessen the volume of trade. While there is a potential for higher tariffs from both candidates, Trump has been particularly vocal about slapping high levies on trading partners. “If you have higher tariffs on imports, we think there could be decreased port activity and by extension a decrease in port revenues,” Close said. Finding opportunity Experts suggest staying away from making any election-based moves until an outcome becomes clear. That said, right now there is an opportunity in the space, said Morgan Stanley’s Brandon. Yields have moved higher and there has been a few weeks of strong supply as issuers try to raise money before the election. He expects that pace to soon slow. In addition, October has historically been a weak month for munis, he said. “More often than not, you are paid to put money to work in October and let it run in November and December,” Brandon said. “We have done a little bit of that.” Brandon particularly likes AA- and AAA-rated muni bonds, notably 4% coupon bonds that are trading at a discount right now. Meanwhile, Byron Anderson, head of fixed income at Laffer Tengler Investments, isn’t taking a lot of duration risk right now and is sticking with high grade bonds that have 10 year maturities and calls under two years. “We are seeing so much volatility right now,” he said. “We just need to get past the election. Markets just never like uncertainty.” If rates go higher, he’ll start locking in once things calm down, he said. However, Nuveen’s Close noted that the intermediate to long part of the curve is now very steep, unlike the Treasury curve. “We are continuing to see really good tax collections and fundamentals and you are getting paid to lend money for longer,” he said. He’s also seeing more money come into municipal bonds as financial advisors look to replace cash as those short-term yields fall. “Munis can have equity-like returns just from clipping your coupons,” Close noted.
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