Several recent developments may affect taxpayers based on a strategy of trading or holding tax-exempt state and local bonds, commonly known as municipal or "munis" bonds. Munis or Muni funds have traditionally been viewed as a tax-advantaged option for low-risk investments, as most are exempt from federal income tax. In many cases, state income tax is issued by the state from which the return is filed.
One of these new developments is an implicit risk that seemed inconceivable not so long ago. Due to huge budget pressures resulting from the COVID-19 pandemic, struggling local and state governments have turned to the federal government for further help, with some leaders publicly suggesting that these jurisdictions could go bankrupt.
Also, the effects of the Tax Cuts and Jobs Act (TCJA) on municipal bond investments, although mostly indirect, can be significant for many taxpayers, especially those who, before the TCJA, were subject to alternative minimum tax (AMT). Other factors include assessments of climate change risks by municipal bond rating agencies. Concurrently, these developments have produced opportunities in some cases and a stimulating environment in others for many taxpayers and their advisers. Although the computational aspect of the investment process remains the same (determining the net after-tax return for comparable corporate and municipal bonds), the growing complexity of the municipal bond market may make it more difficult to conclude risks inherent in a particular market issuance of bonds and whether two bonds are "comparable."
The Tax Cut and Jobs Act's Tax Impact
Perhaps the most important tax aspect of the TCJA, in terms of investments in municipal bonds for non-corporate taxpayers, was the sharp reduction in the number of taxpayers subject to the AMT.
Various factors, such as significant increases in AMT exemption, elimination of Personal exemptions, as well as the limitation of national and local tax deductions, have contributed to a significant decrease in its applicability.
A major investment opportunity created by the reduced application of AMT may increase private equity securities' profitability, such as interest on specific private equity securities (exempt private equity securities). Tax issued after August 7, 1986, subject to certain exceptions, is a privileged AMT element added to the replacement minimum taxable income. In general, equity securities -investment is tax-exempt securities (for tax purposes) the benefit or use of a private entity.
The reduced application of AMT, especially about local and state tax refunds, may also affect municipal bond investment options. Under the previous law, the AMT clause could often encourage many taxpayers to avoid municipal bonds outside their home state. This would arise when the taxpayer's home state exempts its interest from municipal bonds, but subjects the interests of other states to income tax. However, with a very small application of the AMT, far fewer taxpayers will be incentivized for AMT purposes to evade financing income that generates income taxes at the state and local level. However, the incentive to avoid state and local taxes under regular tax provisions can often be even stronger, especially for taxpayers whose local and state taxes exceed the TCJA limit of $10,000 for their deductibility under section 164 (b)(6).
Municipal Bonds Market
Regarding the supply side, the removal by the TCJA of the tax exemption for new securities with early redemption eliminated the new offers for these securities without taxes. These bonds, which act in the same way as mortgage refinancing, in which higher-rate debt is replaced with lower-rate debt, was responsible for about a fifth of new municipal bond offerings. Overall, at the end of 2019, the total municipal bond market of around $ 4 trillion declined slightly over the year.
In terms of demand, the reduction in the TCJA of the corporate tax rate from a maximum marginal rate of 35% to a fixed rate of 21% has made municipal bonds less attractive to corporate investors. For example, in the commercial banking sector, demand has largely shifted from non-taxable municipal bonds to other alternatives, such as asset-backed and mortgage-backed securities and taxable bonds.
Overall, however, demand for municipal bond investment has been strong in recent years, as evidenced by the record entry of $ 93.19 billion in municipal bond funds in 2019, easily surpassing the previous record of $ 81.06 billion in 2009.
However, in 2020, munis were not immune to the effects of the COVID-19 pandemic. In the two weeks ending March 25, 2020, investors withdrew nearly $ 27 billion from municipal mutual funds, while state and local governments only sold $6 billion of the $ 16 billion in bonds they sought to issue from March 9 to 20.
The emergence of Green Bonds
A related development on the climate change front has been the emergence of so-called "green bonds." Per the International Capital Markets Association, green bonds are an instrument in which funds are used exclusively to refinance or finance green bond projects. Companies can also issue these bonds, which are used by government agencies to implement environmental and sustainable initiatives, being the most common use for water and sanitation projects.
A continuing challenge for green bond issuers who hope to achieve such a "greenium" is that market recognition of the "green" status may require high costs for more detailed information and/or external certifications.
Munis Reassessment
Since TCJA's approval, demand for municipal bonds has been high, especially among individual investors, as evidenced by the record flow of mutual funds into the municipal market. One of the possible reasons is the very narrow scope of the AMT, which could have broadened the private securities market. Another plausible reason is the greater clarity and transparency in the price structure of securities after the promulgation of FINRA Rule 2232.
However, uncertainty and potential risks for investors are also developing on new fronts. This includes the emergence of climate change as a major credit rating factor and the COVID-19 pandemic. The latter is against the backdrop of unprecedented debt restructuring in Puerto Rico, which could have implications for future markets municipal bonds. Therefore, investors seeking after-tax comparisons between corporate bonds and equivalent municipal bonds should be warned that this inherently complex determination has become even more problematic than in the past.
Puerto Rico Debt Restructuring
On September 27, 2019, the tax council created within the framework of PROMESA launched a Puerto Rican debt restructuring plan. The plan's payment structure, which differs significantly from traditional bankruptcy plans, could serve as a model for states like Illinois and New Jersey, which have a big debt. In the spring of 2020, when the COVID-19 pandemic depleted local and state government funds and revenues, Senate Majority Leader Mitch McConnell of R-Kentucky said he believed states should be able to declare pause. Although under the Bankruptcy Code and the US Constitution, states cannot declare bankruptcy even before the PROMESA, could not restructure its debt through procedures similar to bankruptcy. Therefore, investors and/or potential government bond investors should be aware that while Puerto Rico's restriction sets a precedent for future congressional action, default protection might not be so secure as before.
Further, the Puerto Rico restructuring is notable for the congressional legislation that made it possible and how the tax board's plan mandates the distribution of assets to its creditors. Although, for example, Puerto Rico's constitution places general bondholders well ahead of pension recipients, the restructuring plan provides for payment cuts of 45% on average for bondholders and no more than 8.5% for retirees.
Given the Puerto Rico restructuring, clients who invest in non-taxable single-state funds should be reminded or cautioned that these funds often hold Puerto Rico bonds to generate higher income and/or provide diversification and tax-exempt in all 50 states due to Puerto Rico's status as a territory.
The Finra Rule Improves Transparency
A continuing challenge for individual buyers of municipal bonds is the relative lack of transparency in selling municipal bonds. Unlike stocks, municipal bonds are not traded on an exchange. Because the market is so large, with over a million issues, it may not be possible to definitively determine, for any given day, which day is the fair price market for a municipal bond. Additionally, before May 14, 2018, brokers were not required to disclose their margins (meaning the margin's value could be incorporated into the share's selling price), which exacerbated the risk that an investor does not pay a fair price for a bond placement.
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