Author’s Note: Members of the Yield Hunting! marketplace service received this report in advance, which may have resulted in a better entry price.
What is next for muni bonds?
Given the issues occurring in Washington, D.C., the prospect of tax reform is quickly waning and the reflation trade fading. The policy overhang that walloped munis late last year is starting to shift market conditions for the space.
While it is likely too soon to say “everything is awesome” and policy risk is zero, the relative valuation continues to signal that munis are a buy here. But risks are likely to be more sector-specific. While tax reform could affect munis in a broader sense due to lower tax-equivalent yields, other regulations and laws could hit other areas of the market.
Health Care Munis
For instance, the repeal and replace of the Affordable Care Act (ACA) could lead to reduced coverage, especially in private insurance among younger adults. The law gave subsidies for those who didn’t qualify for Medicaid to purchase private insurance on state exchanges. It also had taxes built in to pay for those subsidies, in addition to cutting Medicare reimbursements and other programs designed to help for lower income families.
Some lawmakers have proposed a shift to Medicaid block grants in order to give the states more flexibility in spending those federal dollars. This, in addition to removal of the individual and employer mandates, could mean the elimination of coverage, or trading down to a lower level of coverage. Many people who previously were on lower coverage plans were forced to switch when the ACA was passed. This would reverse that trend.
These actions are likely to lead to greater numbers of uninsured who are forced to use the emergency room for care, as well as higher bad debt expense. The end-result is a higher amount of unpaid care and shift in the payor mix. Reduced revenues are also likely, which could pressure providers to adapt their business models.
The question surrounding tax reform continues to flow through the media, but no real concrete policy or the prospect of policy legislation passing appears likely. We have harped on the media narrative on the reflation trade and the unlikely probability of a much higher rate of inflation due to the policy promises from the new administration. Our thesis has been that the market is embedding a perfect game pitched by the Trump administration, something that is unlikely to occur.
Many investors have sold or avoided munis because of the tax reform overhang. These overhangs have existed for decades given the downward trajectory of marginal tax rates. In the 1950s, marginal rates were above 90% (think of those tax-equivalent yields!) and were reduced piecemeal over time to a low of 28% in 1986 before rising again. Still, despite those tax reforms, the municipal bond market continued to thrive.
On the Trump blueprint proposal for tax reform, the tax deductibility of state and local taxes was…