On November 16, 2017, I had written about the importance of tax-exempt advanced refundings as they were being endangered by the Tax Cuts and Jobs Act.
Well, the tax bill was signed and unfortunately, tax-exempt advanced refundings are no longer permitted (tax credit bonds fell victim as well). Many municipalities had utilized tax-exempt advanced refundings for debt service savings through interest cost reductions and debt restructuring. The loss of this valuable tool is a blow to the many agencies who acted as good stewards of their limited repayment resources. The beneficiaries of these savings ranged from taxpayers to operating budgets to obligors of the debt. While districts may still advance refund bonds, they now have to do so with taxable bonds, and taxable bonds are more expensive than tax-exempt bonds.
In addition to removing advanced refundings and tax credit bonds, the other major economic provisions of the tax bill were to reduce tax rates for individuals and corporations while limiting deductions for state income taxes, property taxes and interest on new mortgages.
The Impact to the Municipal Market Will Be Driven By Supply and Demand
Quick disclaimer: I studied economics at UCLA, but I make no claim to being an economist (in other words, these thoughts are for discussion purposes only and not to be taken as predictions or relied upon in any way). Politics aside, these major changes make for a fascinating economic case study as municipalities and investors adjust to this uncertain environment.
Tax-exempt advanced refundings historically comprised about 25% of municipal bond issuances. All things equal, lower supply would make tax-exempt municipal bonds more desirable, increasing bond prices and lowering interest rates (bond prices and interest rates have an inverse relationship).
Offsetting this is the reduction in tax rates for individuals and corporations. When you have lower tax rates, you may be less incentivized to seek tax-exempt debt instruments.
California in particular is a high income tax and high property tax state. Limiting the deduction on state income and property taxes to an aggregate $10,000 cap and limiting the interest deduction on new mortgages removes large itemized deductions for certain individuals. This could partially or wholly undo the individual tax rate reduction depending on the situation, and favors seeking tax exemption.
Which tax bill provision will have the greater impact to interest rates? I haven’t the slightest clue. I’m not an economist.
Lower supply (no more tax-exempt advanced refundings) will be set against a backdrop of lower demand (lower individual and corporate tax rates) partially or wholly offset by higher demand (limited itemized deductions).
Municipalities May Also Add Their Own Wrinkle
California school and community college districts will also adjust to this new tax bill. They typically sold their bonds with a 10-year optional redemption date. Removing tax-exempt advanced refundings means that these municipalities generally could not refinance their debt for 10 years. A possible response? Sell bonds with shorter call dates to preserve refinancing optionality. Generally speaking, a shorter call date should come at a higher interest cost and be less desirable to investors. Add this possibility to the already uncertain impact of the supply and demand scenario and you get the municipal bond market post Tax Cuts and Jobs Act.