Pub. 4 2016 Issue 4

www.uba.org 10 I n the wake of the election, to say anything with absolute cer- tainty isn’t possible. Such is the case regarding the impact of Trump’s tax policies for the tax-free municipal sector. What we do know is that the Trump administration shouldn’t have much difficulty cutting taxes under the Republican controlled House and Senate. As of this publication, the basics of Trump’s policies that could impact the Muni market include the following: • Reduce the corporate tax rate to 15% • Reduce the top marginal tax bracket to 33% • Increase infrastructure spending Market Impact The resulting sell-off in tax-free Munis has been pretty drastic. The last time we saw yields increase this much over such a short period of time was during the taper-tantrum of 2013. The ques- tion is whether or not the recent increase in yields will be equal- ly short-lived. On the surface, this doesn’t appear to be the case, with the market projecting higher interest rates and increased levels of inflation. However, fears of demand drying up as a result of Trump’s tax policies have been largely overblown. There’s a common misconception in the Muni market that buy- ers are exclusively those in the highest tax brackets. Researchers Bergstresser and Cohen from MIT found that from 1995 to 2013, the average marginal tax rate for individual municipal holders was 29%, weighted by position. This is a far cry from the current highest marginal tax rate of 43.4%. Exhibit 1 shows that individuals, either through direct purchases in the retail sector or through mutual funds, have held approximately 78% of municipal bonds outstanding since 1996. It’s this key demo- graphic that drives long-term demand in the municipal sector. Exhibit 1: Individuals Hold an Average 78% of Municipals Responses to Tax Rate Changes The last time tax rates were cut was in 2001, under the George W. Bush administration. By 2003, Bush had successfully cut the highest marginal tax from 39.6% to 35%, while the highest cor- porate tax rate remained at 35%. Exhibit 3 shows the response in 10-year Muni and 10-year Treasury yields during this time. From 2001-2004, 10-year AAA Bank Qualified (BQ) Muni yields averaged 3.94% with a Muni-to-Treasury ratio averaging 92.7%. The two biggest spikes in Muni yields over this span occurred in June 2003 and March 2004. The June ‘03 move saw Muni yields increase 104bps from 3.07% to 4.11%. Yields subsequently retraced all but 23bps of this move until March of the following year when Munis sold off in a similar short-lived fashion, a 100bps increase to 4.31%. By the time the dust settled in December 2004, 10-year BQ Muni yields actually fell 72bps to 3.71% compared to the start of the Bush tax cuts in 2001. The take away here is that when tax rates were cut under the Bush administration, yield spikes in the Muni market were short lived. What market participants should expect going forward is more volatility. (See Exhibit 2: Bush Tax Cuts - Yield Spikes Were Short Lived). Market Considerations - Trump’s Tax Plan By Drew Simmons