Municipal bond buyers appear cool in the face of a potential threat to the tax exemption from Congress, but warn that if it does happen, trading would plummet as investors hold on tight to existing tax-exempt paper.
If lawmakers do move to trim or eliminate the tax exemption on future muni paper, portfolio managers said they expect a rise in the value of outstanding bonds, but only a modest one as market technicals and current valuations would restrain a meaningful rally.
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Buysiders were even less concerned about the notion that lawmakers would move to
If Congress did eliminate future tax-exempt debt, the move would likely spark
The rush of supply would likely be met with a wave of demand, said Wesly Pate, senior portfolio manager at Income Research + Management.
"So you wind up with a uniquely, near unchanged equilibrium point in terms of valuation that doesn't lead to any meaningful moves," Pate said.
Eliminating the tax exemption on future bonds would lead to only a "modest" rise in prices for outstanding tax-exempt debt based on current market valuations, he said.
"And the reason it's modest is because potential price moves have to be grounded in where present valuations are," he said. The five-year Municipal/Treasury ratio — which "accounts for the traditional investment activity of the retail buyer" — is currently at 63%.
"That's not too far off of the reasonable low of one minus the top marginal tax rate," Pate said. "Any sort of change that leaves outstanding debt exempt is not going to create a meaningful rally given starting ratios."
Craig Mauermann, a portfolio manager and managing director for Thornburg Investment Management, agreed that outstanding tax-exempt bonds would likely see only a "small" rise in value if Congress eliminated the exemption on future debt.
"Municipal bonds are currently priced to be attractive to investors relative to other investing options. So, there would not suddenly be a large change in relative value," Mauermann said.
"While there could be an aspect of scarcity value that could come into play in some small way, ultimately when people are buying — whether they're buying a municipal bond or a corporate bond or a Treasury — they're going to be looking based on … their own tax expectation for themselves whether or not a particular investment makes sense," he said.
The bidding up of existing tax-exempt bonds would bring down their yields, he said. So "if they rallied a little bit and the yield went down a little bit, at some point then people are going to say well now it makes more sense for me to buy the taxable bonds," he said. "It's still the same after-tax calculation."
The loss of the tax exemption would diminish secondary market liquidity as more buyers hold onto the now-precious exemption, said buysiders.
"You would definitely have more investors who just hold [the paper] until it matures or it's called," Pate said. As future tax-exempt primary issuance dwindled, mutual funds and exchange-traded funds would begin to shrink in size as well, he added.
While trading on tax-exempt bonds would "plummet," a taxable muni market would attract a wide array of new investors, said Pat Luby, senior municipal strategist at CreditSights.
"There's an enormous universe of investment grade investors who would crave the opportunity to add muni credit risk to their portfolios — they'd like to do it now but can't justify it because it's too rich," Luby said. There would be a "scramble" for muni products, and vehicles like exchange-traded funds and closed-end mutual funds would likely no longer trade at a discount, Luby added.
"The downside is there would absolutely be some losers," he said.
While high-profile, frequent issuers like states or large hospitals systems would be able to pivot to the taxable market, smaller, less-well-known borrowers would see a big spike in borrowing costs, he predicted.
"There's a large part of the market that doesn't have the resources to increase the costs on their beneficiaries, like a small nonrated utility that needs to repair their sewage waste plant or a small rural hospital," he said. "If their cost of renovating a project or building a new ICU doubles or triples, the cost of providing rural quality health care is going to be crippling," he said. "It's a huge concern, not just as muni market participant, but as a citizen and a taxpayer."
