President-elect Trump has called for increased spending to rebuild infrastructure. This, coupled with calls for tax reform, has municipal bondholders nervous that the federal government will limit or end the tax exemption on their bonds as a way to partially pay for this program. Although possible, we do not believe this is probable for the following reasons.
Municipal bonds have long been the primary financing vehicle for infrastructure spending in the United States. The federal government has stayed largely out of the process, allowing states to price their own deals. The belief has been that this lowers net interest cost as it is more efficient to finance on the local level. Although the federal government could use the revenue, we think that ending the municipal bond tax exemption could lead to court challenges. While tied up in court, new projects might be delayed or canceled, leading to pressure on politicians. This, coupled with the increased borrowing costs as investors demand more yield for the volatility, would diminish the benefit of new revenues collected from municipal bonds.
Another reason we do not see this as probable is the negative impact on the largest buyer, the retail investor. According to the Securities Industry and Financial Markets Association (SIFMA), more than 40% of municipal bonds, totaling more than $1.6 trillion, are held by individuals. This number increases to 70%, or more than $2.6 trillion, when mutual fund holders (including money market mutual funds) are included. Many holders are elderly and rely on tax-exempt income for retirement. They constitute an active voting group that would be very unhappy with changes to its fixed income payments. In addition, they could seek legal recourse because bond deals were marketed and sold to them as tax-free.
In conclusion, the increased costs associated with restructuring the bonds would likely be prohibitive. And even if a change occurred, the process would take years and the bonds that have already been issued would more than likely be grandfathered. In other words, all bonds issued before the tax changes would likely remain tax exempt, increasing the value of existing municipal portfolios. We will continue to watch this issue as more certainty around the incoming Trump administration’s plan of action emerges.
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