Challenges and Opportunities for U.S. Municipal Market
As investors assess the capital market outlook over the near and medium term, the U.S. municipal market faces potential legislative initiatives which could influence performance as well as provide additional areas of opportunity for both traditional and non-dollar municipal investors. The following examines two large policy initiatives being discussed in Washington and how they might impact the U.S. municipal market going forward.
- Tax Policy Changes – Directionally, both the administration and Congress are in favor of reducing marginal tax rates. Since most of the U.S. municipal market is federally tax-exempt, lowering tax rates reduces the benefit afforded by investing in tax-exempt municipals. While it is important for investors to be aware of the potential impact of tax changes, it is also important to note that relative valuations in the municipal market are reflective of a wide variety of factors that reach beyond marginal tax rates. Credit quality, liquidity, yield and correlation characteristics, among others, all play a critical role in the valuation and performance of individual securities as well as the market in aggregate. Municipal market valuations have tended to exhibit limited correlation to changes in top marginal tax rates. Historically large reductions such as occurred in 1987 when top rates dropped from 50% to 38.5% and 1988 when rates were cut to 28% had no discernible impact on municipal versus Treasury valuation ratios. In today’s environment, municipals have the benefit of a ‘valuation cushion’ as investors move out across the yield curve. Ratios beyond 10 years currently exceed 100% of Treasury yields.
- Infrastructure Investment – The administration has expressed a desire for a large infrastructure investment program to stimulate economic growth and to help lay the foundation for future gains in productivity. They also favor utilizing the Public Private Partnership model (P3) as a means of introducing efficiencies and harnessing private capital. This model can be effective for certain types of infrastructure projects. It has been used selectively to fund toll road and airport expansion projects, among others, and projects which have a steady stream of user fees available to provide a return on capital.
Prospects and Outlook
Overall, we expect that progress on policy initiatives will take longer and likely be moderated as the process moves forward. Now that the administration’s first policy initiative, Repeal and Replacement of the Affordable Care Act, has come to an abrupt end, Congress will now begin to debate tax policy changes. We expect the desire for deficit control will ultimately curb consideration of the most aggressive rate reduction plans and ultimately move in the direction of modestly lower rates combined with efforts to broaden the tax base.
Infrastructure investment, which should be the easiest to accomplish legislatively, falls last on the agenda. We expect there to be strong interest in the municipal sector from both U.S. and non-dollar investors if the program follows a traditional path. Increased issuance for infrastructure investment, potentially involving taxable issuance and a developing credit cycle, points toward heightened investor interest in diversifying asset exposure. The U.S. municipal market can expect to serve an increasingly broader array of investors as the reach for good quality, higher yielding, and longer-term assets evolves.
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