Next Week’s Presidential Election: A Potential Earthquake for the Municipal Bond Market
The upcoming presidential election is poised to significantly impact the municipal bond market, according to leading financial experts at Morgan Stanley and Nuveen. The outcome could dramatically alter tax policies, potentially triggering shifts in investor demand and reshaping the landscape of this vital sector. The expiration of key provisions from the 2017 Tax Cuts and Jobs Act (TCJA) adds another layer of complexity, leaving the future of several crucial tax benefits uncertain. Whether it’s the fate of the SALT deduction, the AMT exemption, or the corporate tax rate, the election’s outcome will have far-reaching consequences for municipal bond investors.
Key Takeaways: What You Need to Know
- The election could be the **most influential** in recent history for the municipal bond market.
- Expiration of the TCJA’s provisions in 2025 creates significant uncertainty regarding tax benefits affecting municipal bonds.
- Potential changes in tax brackets, SALT deductions, Alternative Minimum Tax (AMT) exemptions, and the corporate tax rate will heavily influence **muni demand**.
- Certain muni sectors, such as healthcare, education, and ports, are particularly vulnerable to policy changes under different administrations.
- Experts recommend **avoiding election-based trading decisions** until the results are clear, but opportunities exist in the current market conditions.
The Looming Expiration of the TCJA and its Impact
The 2017 Tax Cuts and Jobs Act introduced several provisions impacting municipal bonds, many of which are set to expire at the end of 2025. These include lowered federal income tax brackets, a $10,000 cap on state and local tax (SALT) deductions, and increased alternative minimum tax (AMT) exemptions. Craig Brandon, co-head of municipals at Morgan Stanley, stressed the significance of this impending expiration: “This is probably the most important election we have seen in a really long time as far as impact on the muni market.“
Tax Bracket Changes and Muni Demand
If the lowered tax brackets sunset, the highest tax bracket will revert to 39.6% from 37%. This increase would make the federal tax exemption on muni bond interest more valuable. Dan Close, head of municipals at Nuveen, illustrated this: “A muni bond yielding 5% has a taxable equivalent yield around 7.9% under the current 37% rate. With the 39.6% tax, the taxable equivalent yield goes to 8.25% for taxpayers in the highest bracket.” However, Brandon noted that studies suggest relatively small changes in tax rates don’t significantly alter muni demand. He clarified: “If you have a major change in rates it could impact the demand for munis.“
The Crucial Role of the AMT
Changes to the AMT could have a more profound effect on the municipal bond market. Brandon pointed out a critical aspect often overlooked: “I don’t think people realize that there is a pretty large part of the muni market where the coupon is exempt from ordinary income, but it is not exempt from the AMT.” Airport bonds are one example. The TCJA increased the AMT exemption, but its reversal could significantly impact investor interest in these bonds. “There are not many people left paying AMT now,” Brandon explained. Investors currently buying AMT bonds receive a yield premium, which is likely to disappear if the AMT returns to pre-TCJA levels. “If the AMT comes back to where it was under a Harris administration, that will impact demand for those bonds. People may not want those bonds.” Less demand would widen spreads.
The Corporate Tax Rate’s Influence
US banks and insurance companies hold approximately 25% of all outstanding municipal bonds. The corporate tax rate directly impacts their investment choices. When the rate was 35%, munis were attractive. After the TCJA reduced it to 21%, corporate bonds became more appealing. A potential increase to 28% under a Harris administration could, therefore, boost demand for municipal bonds as these institutional investors rebalance their portfolios. “At the margin at least, those banks and insurers would sell their corporate bonds and ramp up their muni allocations,” Brandon added.
Sector-Specific Impacts: Healthcare, Education, and Ports
Nuveen anticipates that certain muni sectors will be disproportionately affected by policy changes. Close highlighted the potential impacts on healthcare, education, and ports:
Healthcare
In the healthcare sector, a Republican victory could facilitate hospital mergers and acquisitions but potentially hinder their profitability, due to Medicare and Medicaid reimbursement rate challenges. “We think that there is going to be a lot of privatization or a greater potential for insurers playing a larger role in administering Medicare and Medicaid,” Close stated. “It means less negotiating power and lower reimbursement, potentially.” A Democratic win would likely reduce the likelihood of mergers.
Education
While education funding is predominantly at the state and local levels, federal influence remains significant. A Republican win could favor charter schools over public K-12 programs and increase the likelihood of taxes on endowments. Close explained, “There is also a higher probability of some taxes on endowments for institutions that have been in the crosshairs of Republicans, which could be a potential headwind for credit.” Student loan forgiveness policies would also be affected, potentially impacting higher education. Conversely, a Democratic victory would likely be more supportive of education muni bonds, increasing the probability of student loan forgiveness, increased funding for community colleges, and more spending for K-12.
Ports
Increased tariffs could negatively impact ports, leading to reduced trade volume and revenue. While both candidates have mentioned potential tariff increases, Trump’s more vocal stance on imposing high levies on trading partners poses a higher risk. “If you have higher tariffs on imports, we think there could be decreased port activity and by extension a decrease in port revenues,” Close warned.
Navigating the Uncertainty: Investment Strategies and Opportunities
Experts advise against making election-driven investment decisions before the results are known. However, current market conditions present some attractive opportunities. Brandon observes that yields have increased, and there has been a surge in issuance ahead of the election. He anticipates a slowdown in issuance post-election and highlights historically weak October performance in the muni market. “More often than not, you are paid to put money to work in October and let it run in November and December,” Brandon noted. He favors high-quality (AA- and AAA-rated) muni bonds, particularly those with 4% coupons currently trading at a discount.
Anderson, head of fixed income at Laffer Tengler Investments, is prioritizing low duration risk with high-grade bonds, focusing on 10-year maturities and calls under two years. He explains, “We are seeing so much volatility right now. We just need to get past the election. Markets just never like uncertainty.“
Close draws attention to the steep intermediate-to-long end of the municipal yield curve, currently exceeding that of treasuries. “We are continuing to see really good tax collections and fundamentals and you are getting paid to lend money for longer,” he said. Furthermore, he highlights the inflow of funds into municipal bonds as financial advisors seek alternatives to low-yielding cash. “Munis can have equity-like returns just from clipping your coupons,” Close concluded.
