Capital Ideas^™ 
Investment insights from Capital Group

The storm before the calm?

What a difference a month makes. Late last year, municipal bond prices declined as new issues flooded the market. Uncertainty around tax reform and the potential for the municipal exemption to be scaled back for non-profit bond issuers such as universities and hospitals had unsettled the market.

Early versions of tax reform legislation proposed wide-ranging changes. Some of the measures considered could have greatly affected both supply (in terms of which entities could issue tax-exempt bonds) and demand — due to changes in marginal tax rates for investors.

Fast forward to the present — municipal bonds have recovered some lost ground, and markets have mostly been calmer. As anticipated, tax reform has reduced various federal tax rates, especially for corporations. The most significant potential changes to the types of issuers that can benefit from the exemption did not make it into the final bill.

Critically, the tax exemption of interest earned from municipal bonds was untouched. Even so, one question looms large: Has tax reform changed the big picture for investors in municipals? On balance, I don’t believe so.

Overall, my near-term outlook has not radically changed in the wake of the Tax Cuts and Jobs Act. For tax-aware investors, the bottom line is that higher quality municipals remain a compelling option for core fixed income allocations in 2018. Here’s why:

1. Reduced demand from investors is unlikely to be a large negative factor.

One concern voiced by some market commentators is that reduced demand for municipal bonds from investors will put downward pressure on bond prices in 2018. With reduced tax rates, the argument goes, lower after-tax yields will undercut the appeal of munis. 

I’m unconvinced that the impact will be as significant as some have argued. Individuals in the highest federal income tax bracket will get a modestly smaller tax advantage from holding municipals rather than other high-quality taxable bonds, as the top marginal rate dropped from 39.6% to 37%.

Banks and insurance companies have historically been important participants in the municipal market. For them, the cut in the corporate tax rate from 35% to 21% does substantially reduce the tax advantage of holding municipals. While the lower rate may reduce demand on the margin, our research suggests that the new tax legislation is unlikely to turn these entities into outright sellers.

For corporations — as well as many other investors — yield is only part of the appeal of municipal bonds. 

2. Municipals still offer true core portfolio benefits — even after tax reform.

The after-tax income potential of municipals outshines comparable taxable bonds — even after factoring in a lower effective top individual income tax rate. At recent market levels, the reduced tax advantage in 2018 (compared with 2017) equates to a taxable-equivalent yield for municipals that is about 0.2 percentage points lower.

Diversification is another key reason to invest in municipal bonds. The municipal market’s history of relatively low correlation to equities certainly checks that box. For tax-aware investors who are seeking a true core fixed income allocation, municipals are still well worth considering.

3. In-state bonds may shine brighter for investors in high income-tax states.

Tax reform has reduced the state and local tax deduction for many taxpayers. While this change may leave some individuals in high-tax states feeling the pinch, it’s a development that could in the near term be favorable for municipal bonds issued in states with high income taxes.

In New York and California, for instance, the doubly tax-exempt nature of in-state bonds may become more highly prized by residents in higher income tax brackets. It’s far from conclusive, but recent yield moves have been consistent with this kind of change in demand.

My thoughts on the year ahead

Municipal bonds rallied substantially in 2017, and investors should expect more muted absolute returns in 2018.

Amid elevated valuations, putting greater emphasis on higher quality bonds seems appropriate. This kind of thinking has been reflected in the recent portfolio positioning of The Tax-Exempt Bond Fund of America®. (I’m a portfolio manager for this fund, one of our core tax-exempt fixed income strategies.)

At current municipal bond valuations, a rise in Treasury yields — perhaps in response to interest rate hikes by the Federal Reserve — could be a headwind for near-term municipal returns.

Policy developments may also present challenges in 2018. The repeal of the Affordable Care Act’s individual mandate is a recent example. Our investment analysts are carefully considering how this development may affect different issuers and create both risks and opportunities over time; historically, health care has been a large sector exposure for many of our tax-exempt bond funds.

Any renewed volatility — prompted by the Trump administration’s policy efforts regarding infrastructure or health care, for example — could present attractive buying opportunities for investors with a long-term perspective.

I also remain excited about some enduring themes reflected in The Tax-Exempt Bond Fund of America’s portfolio. Our focus on revenue bond issuers in sectors such as transportation, public power, housing and education offer ways to invest around the pension and other long-term liability issues confronting state and local governments.

Not-for-profit hospitals are another great example of an enduring theme. Even in an uncertain health care sector, we have found favorable return potential amid a wave of consolidation. Across issuers, sectors and regions, I expect our emphasis on bond-by-bond research will continue to uncover compelling risk-adjusted relative value opportunities.