Much has been written about the likelihood of some kind of tax reform coming out of the new congress/administration. Consensus expectations seem to be lower tax rates for both corporations and individuals, possibly as early as later this year. While discussing changes in tax rates, tax reform, tax simplification, etc. seems to be an ever-present conversation in Congress, often little if anything is actually accomplished. However, given the current make up of Congress, the odds currently seem rather high that this time will be different, and that something will actually happen later this year or early next year. Changes in tax rates in the name of fiscal stimulus seems the most likely course of action while true tax simplification seems the most difficult to accomplish. With many lobbyists, special interest groups, tax attorneys and others fighting to keep every line of the tax code that benefits their clients intact, meaningful tax reform has always been and continues to be a difficult task.
Yields in the municipal markets have shown very little to no adjustments suggesting they are factoring in the effects of lower tax rates on after tax municipal yields. Municipal yields as a percentage of U.S. Treasury yields have remained relatively constant since the election, indicating that municipal buyers remain skeptical that meaningful changes in tax rates will occur. To quantify this, a current 10-year AAA municipal bond yields 2.34% or a taxable equivalent yield of 3.77% for an individual in a marginal tax rate of 38%. If that top/marginal tax rate is reduced through tax reform to 28% then the yield on the AAA municipal bond needs to increase from the 2.34% mentioned above to 2.72% in order to maintain the 3.77% taxable equivalent yield. This does not imply that the markets will fully bump yields to reflect the example above, but some adjustment seems likely.
We continue to believe that the adjustment in after tax municipal yields will be very modest given the fact that 10-years AAA municipals already yield almost as much as comparable maturity U.S. Treasury issues. This implies that the tax-free treatment is currently almost “for free” less whatever credit spread premium investors demand to purchase AAA municipal issues instead of Treasuries. We will continue to actively monitor this tax reform debate and factor any events that occur which are significantly different than our expectations expressed above into our investment decisions. If you have any questions, please don’t hesitate to reach out to
Jim Bernard, CFA, is the Managing Director, Fixed Income at Ancora Advisors LLC a SEC Registered Investment Advisor. He is also a Registered Representative and Registered Principal of Inverness Securities, LLC. (Member, FINRA/SIPC)
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