What A Trump Presidency Means For Muni Bonds

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By James Dearborn, Head of Municipal Bond Investments and Senior Portfolio Manager

Expectations about proposed Trump polices led to a sell-off in the municipal bond market. Despite the recent volatility, we think munis are still an attractive option for investors looking for tax-advantaged income.

The municipal bond market sold off in the days following the election on expectations of lower taxes and higher inflation, among other reasons. We caught up with Head of Municipal Bond Investments James Dearborn to get his take on what President-elect Trump's proposals could mean for municipal bond investors.

Q: Why did municipal bonds sell off after the election?

The muni bond market followed the large sell-off in the Treasury market, which sold off after the election as the market priced in the potential for rising inflation. These sell-offs were based on the belief that increased federal spending on defense and infrastructure, combined with tax cuts and reduced regulations, could accelerate economic growth at a time when the labor market is already tight - all leading to higher inflation. Additionally, many of the proposed Trump policies create the potential for increased federal borrowing - more Treasury issuance and larger deficits.

While it is possible that this inflation scenario plays out as the market anticipates, many factors may limit the inflationary forces of the proposed policies. It is possible that the market has overreacted to some of the proposals. Importantly, we remain late in the economic cycle, and to-date, inflation remains modest, although it has accelerated in recent months.

Q: What does potential tax reform mean for municipal bond investors?

Trump's tax reform plan calls for a reduction in personal income tax rates, possibly from 39.6% to 33%. The value of the municipal bond tax exemption decreases when tax rates fall. Conversely, it increases when tax rates rise. Lowering the top marginal federal rate from 39.6% to 33% would marginally reduce the value of municipal bonds.

The top federal tax rate in 2012 was 35% (it rose to 39.6% in 2013 as a result of the "fiscal cliff" negotiations), not much higher than a potential 33%. On an after-tax yield basis, even at the potentially lower top federal rate, we still believe municipal bonds are an attractive investment for tax-sensitive investors.

Trump's proposals address neither the 3.8% Net Investment Income Tax (NIIT) nor state income tax rates. Even with a 33% federal tax rate, rates remain high. For example, the all-in federal rate would be 36.8% (33% + 3.8% NIIT) and the combined federal/state rate would be 45.7% in California, 42.7% in New York and 43.4% in Oregon.

Q: Does the tax reform proposal address the muni interest exemption?

President-elect Trump's tax proposal doesn't include the treatment of tax-exempt interest. However, tax reform discussions in recent years have included the municipal interest exemption, and we expect this topic to be on the table once again.

Q: Are BABs (Build America Bonds) likely to return?

BABs are taxable muni bonds created as part of the American Recovery and Reinvestment Act in 2009 and issued between April 2009 and 2010. Trump has expressed support for BABs in order to "provide maximum flexibility to the states." A new BABs program shouldn't be a negative for the muni market, as BABs issuance is likely to replace (rather than add to the supply of) tax-exempt muni issuance.

Q: How does the large increase in proposed infrastructure spending impact the muni market?

Most infrastructure spending is financed through traditional tax-exempt muni bonds issued by state and local governments and their agencies and authorities. Given the importance of muni bonds in financing infrastructure, changes to the tax code that reduce or eliminate their tax exemption seem unlikely. State and local officials will strongly argue that any changes to the treatment of municipal interest would increase their borrowing costs, reducing their willingness to invest in infrastructure.

Q: Would changes to the tax code be implemented on a retroactive or prospective basis?

While the answer is unknown, many members of Congress have spoken out against retroactive changes (essentially changing the rules after the game has begun) that would undercut the value of existing muni bonds. They have shown a strong preference for preserving the muni interest exemption on existing bonds and making the changes relevant only to newly issued bonds. We believe outstanding municipal bonds could increase in value, should tax code changes be applied on such a forward-looking basis.

Bottom line

The sell-off in muni bonds reflects market expectations about the impact of President-elect Trump's proposed policies. But we think the market may have overreacted. It's true that the possibility of lower tax rates and increased infrastructure spending has increased as a result of the election. But it's also true that the benefits that have made muni bonds a core holding of income-oriented, tax-conscious investors remain intact.

© 2016 Columbia Management Investment Advisers, LLC. All rights reserved.

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