24 SEPTEMBER / OCTOBER 2018 A Tactical Shift In municipal investments Drew Simmons Senior Vice President The Baker Group drew@GoBaker.com The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member. DIRECTORS / SENIOR MANAGEMENT Prior to the beginning of 2018, a year with the largest tax reform measures enacted since the 1980s, many investors were concerned that, under lower tax rates, demand for tax-exempt municipals would fall. So far, that hasn’t played out. The reason for this is twofold: 1. A significant drought in supply; and 2. Tax rates for most muni buyers are only modestly lower. Limited supply for the sector is a simple product of the rate cycle. Interest rates are higher, resulting in less refunding activity. Through July of this year, total municipal issuance was down nearly 17 percent from the same time last year (Figure 1). Moreover, projections for year-end supply might result in the lowest issuance for the sector since 2011. Mutual fund inflows for munis have remained positive. The reason for this is that the largest buyers of munis, individuals and households, experienced only a modest reduction in their tax rates. The biggest drop in tax rates came from a reduction in the top corporate rate from 35 percent to 21 percent. Muni buyers subject to this tax cut include insurance companies and C-corp banks. These institutions make up about 30 percent of muni holders, and it’s here where the market has seen some material changes in demand for certain tax-exempt munis. Prior to the tax cuts, institutional muni buyers subject to the highest tax rates saw positive spreads to Treasuries across the curve. In other words, while the widest spreads to Treasuries were found in longer-dated municipals, there were still positive spreads on even the shortest of maturities. This allowed institutions to ladder out their purchases in whatever way they saw fit and still achieve a yield advantage over taxable alternatives. Today, at a 21 percent tax rate, that’s no longer the case. As shown in Figure 2, the green line represents tax equivalent yields (TEYs) for bank qualified tax-exempt munis at a 21 percent tax rate for various maturities across the curve. At this tax rate, muni TEY spreads are negative to Treasuries (in yellow) inside four years and negative to Agencies (in blue) inside five years. This has created the need for a tactical shift for muni buyers subject to the 21 percent tax rate. Most of these buyers have historically seen better relative value in longer-dated munis. However, for those Figure 1
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