Pub. 4 2016 Issue 4

Issue 4. 2016 11 Yield Impact There’s no denying the diminished value of tax-free Munis given a reduction in tax rates. The biggest impact will be for banks under a C Corp tax status with a proposed corporate rate at 15%, less than half the current rate of 35%. Table 1 below shows the change in tax equivalent yields (TEY) under Trump’s tax rate proposals using a 10-year BQ Muni purchased at a 2% net yield. The TEY for a C Corp bank, subject to TEFRA, is 3.02%. Under a 15% rate, the TEY falls 68bps to 2.34%. For an S Corp @ 43.4%, the TEY falls about 54bps, from 3.53% to 2.99%, under the proposed 33% individual tax rate. All things being equal, lower tax rates should put upward pressure on Muni yields. An investor at the current top tax rate of 43.4% earning a 3.53% TEY should demand higher net yields as compensation. For S corps and individuals, the net yield required to equal the same TEY of 3.53% would need to be 37bps higher at 2.37%. For C corps it would need to be 58bps higher at 2.58%. However, all things aren’t equal. When factoring in that retail buyers represent more than 75% of the market, coupled with the fact that they have only moderate tax burdens, it seems unlikely that demand for higher yields would stem solely from lower tax rates. (See Table 1: Impact on Tax Equivalent Yields). Municipal Investments Strategy Community banks have long relied on tax-exempt munici- pal securities as a substantial portion of earnings in the invest- ment portfolio. Trump’s tax proposals may reduce some of the benefits of tax-free municipals for certain financial institutions under the highest tax brackets. However, given the supply/ demand dynamics in today’s market, it’s unlikely to see a mass exodus from traditional buyers in the tax-exempt sector. As it stands now, the potential reduction in tax rates looks to impact C Corp institutions the most, but not to the point to justify an outright elimination of municipals in the portfolio. n Drew Simmons has worked in the field of finance since 2003. He holds a bachelor’s degree in business administration along with a master’s degree in finance from the Meinders School of Business at Oklahoma City University. As a vice president of The Baker Group, he works with community banks specifically covering interest rate risk, asset and liability management, and fixed income portfolio management. Contact: 800-937-2257; drew@GoBaker.com . Exhibit 2: Bush Tax Cuts - Yield Spikes Were Short Lived Exhibit 1: Individuals Hold an Average 78% of Municipals Table 1: Impact on Tax Equivalent Yields