Independent Thinking^®

Planes, Trains – and Taxes

President Trump’s $1.5 trillion infrastructure proposal, if it comes to fruition, could have a major impact on municipal bond investors. Real investment in the nation’s airports, railways and highways – many in dire need of repair – could increase bond market supply. This, in turn, could increase bond yields and decrease prices, depending on the timing and scope.

That’s a big if, of course. There’s no word yet on where, exactly, resources for an infrastructure plan would come from – and no indication that Congress will agree that the need justifies the cost, hard on the heels of $1.5 trillion in tax cuts. That aside, an infrastructure plan would be very welcome in the bond markets.

As we noted in our publication, Taking the High Road: Investing in America’s Infrastructure, quantifying infrastructure investment – and the related opportunities and risks – is a challenge, but is critically important for the U.S. economy and its long-term competitiveness. ¹ Nationwide, public construction spending appears to be just over 1.5% of U.S. annual gross domestic product – the lowest since 1993.
 
Most of the money spent in the United States on public infrastructure comes from state and local governments, not from the federal government. Of the $416 billion spent in a year, at the Congressional Budget Office’s last count, on transportation and water infrastructure, over 75% was financed through state and local governments. ² Bonds issued to finance further infrastructure improvements, particularly in high-tax states, benefit by demand from buyers looking for tax benefits after the recent federal tax bill has limited state and local tax, or SALT, deductions.
 
Of course, this demand has to be weighed against the competing fiscal challenges often faced by these states including a sluggish economic recovery, lack of budgetary reserves for the next recession, and unfunded employee pension and healthcare benefits. While the federal government’s monetary contribution to infrastructure needs has steadily declined over time, it still holds significant sway over the critical approval process, which can add time and costs to any project.

The United States has a long road to travel in restoring and renewing its infrastructure to the level of its trading partners. Municipal bond investors will be tracking progress with great interest, as it will increasingly fall upon the states and cities to try and remedy this situation, along with the concomitant rise in bond supply that will result.
 
Howard Cure is the Director of Municipal Bond Research at Evercore Wealth Management. He can be contacted at [email protected].

Tax Reform in the Muni Markets

The total impact of the Tax Cuts & Jobs Act of 2017 on the municipal bond market was not as dramatic as many had feared. The tax rate for the top income bracket is still very high, at 37%, so municipal bonds remain attractive. Cumulative inflows are up over $8 billion³ since the beginning of the year and look set to continue rising in the muni markets.
 
However, the extent to which the $10,000 cap on state and local tax deductions will hamper the ability of high-tax states and localities to raise taxes remains to be seen. Residents of high-tax states who were dependent upon the SALT deduction to alleviate some of their burden, may be less amenable to future income and property tax increases to help structurally balance state and local budgets. While some state residents in lower-tax states can benefit from lower federal taxes, the residents in high-tax states, with limits to the SALT deduction, will end up paying more in total taxes.
 
The loss of advance refundings as tax-exempt debt is likely to reduce future supply (hitherto about 15% of total issuance) and makes it more difficult for entities to achieve debt service savings. While more issues could come to market structured with lower coupons, shorter calls, or even as taxable bonds, these are unlikely to replenish the aggregate. The loss of advance refundings also restricts the flexibility of municipal issuers to lower their interest costs.
 
At the same time, demand from banks and insurance companies, which accounted for 23% of the $3.8 trillion market at the end of 2017, could wane as corporate tax reduction makes the yield on corporate securities more attractive.
 
As a whole, the future demand for municipal bonds depends on the extent to which supply can be maintained with appropriate yield rewards, and their relative appeal to the risks and rewards of the equity market. It also depends on the progress of infrastructure planning from speeches to implementation.
 
– H.C.

¹ www.evercorewealthandtrust.com/investing-in-americas-infrastructure/
² Congressional Budget Office Report: Public Spending on Transportation and Water Infrastructure, March 2015.
³ Source: Investment Company Institute; Estimated flows to long-term municipal mutual funds, January 31, 2018.