Tax code adjustments and new legislation can have a significant effect on personal and business finances, particularly as it pertains to managing your investment portfolio. To keep you in the know on important changes, Chesapeake Wealth Management (CWM) Senior Portfolio Manager Richard Ware and Investment Services Manager Beth Swartz share their insights and predictions on how the Tax Cuts and Jobs Act will impact bond holders*.
Tax Cuts & Jobs Act: The impact on municipal, investment and taxable vs. tax-exempt bonds
The biggest event for last year was the signing into law the Tax Cuts and Jobs Act in December 2017. The good news is that tax cuts for individuals and corporations are expected to provide a modest boost to the U.S. economy as consumers and businesses increase spending. More specifically, estimates for an increase in GDP range from 0.2-0.4 percent.
But what is the potential impact on credit markets? For corporations which issue taxable bonds, the reduction in the corporate rate from 35 to 21 percent should benefit their bottom line, which could result in an improvement in credit quality and would reduce their funding costs (lower yields).
Currently, corporations that issue debt can deduct the bond interest payments made to investors, but that deduction will now be capped based on a percentage of their earnings. For investment grade issuers with relatively low debt levels, the cap will not have a huge impact.
Investment grade bonds
Demand for investment grade bonds should remain solid due to historically low interest rates and funding needs, but a shift may occur in the amount of debt issued by certain sectors. This could result in a reduction in overall supply, prohibiting a dramatic rise in rates. However, for those companies which are highly leveraged and are issuing high yield bonds, the cap on interest deduction is viewed as a penalty. Issuing debt by these types of companies may not be as attractive as it once was.
Over time, this could result in better firms within the high yield arena issuing less debt with a smaller, high quality-high yield market with less default risk.
Municipal bond holders
As for the municipal bond market, due to a lack of certainty surrounding the tax reform bill, municipal bond issuers rushed to the debt market in the Q4 of 2017 to get ahead of potential changes. It is expected that the municipal market will rally in Q1 of 2018 as supply will decrease. With lower corporate tax rates and the elimination of corporate Alternative Minimum Tax (AMT), the benefits of owning tax-exempt bonds may not be as compelling as it once was for certain institutions.
Insurance companies and banks have been sizeable buyer/holders of municipal debt and this change may have a negative effect on demand going forward. But there is the thought that excess supply will be picked up by other institutions, mutual funds and exchange traded funds and pressure on rates will be minimal.
Tax-exempt bonds and outstanding debt financing
Another provision to the Tax Cuts and Jobs Act is beginning in 2018, issuers will no longer be able to advance refund their outstanding debt with tax-exempt bonds. Similarly to refinancing a mortgage, bond issuers can issue new debt at lower rates to pay off old debt. This practice is typically done by state and local governments and allows municipal bond issuers the flexibility to reduce their cost of finance and frees up the borrowing authority for additional capital improvements or infrastructure projects at a lower cost to the taxpayer.
The municipal market as a whole should benefit as there will be a reduction in supply from this new provision.
Taxable vs. tax-exempt bonds
Even though individual tax rates will move lower, most in the top brackets will still benefit from owning tax-exempt bonds when comparing relative attractiveness to taxable bonds. There are conflicting factors which could give rise to higher yields, but also many scenarios that imply demand will outweigh supply. Markets have weathered reductions in tax rates before and this time should not be any different. Yields will adjust to new levels, but will always be influenced by supply and demand.
As we have stated before, as demographics change and the population ages, the safety, security and tax advantage of municipal bonds should keep demand steady.
Should you stay in the bond market?
With continued expectations of economic growth and upward movement in inflammatory pressures, we would expect for interest rates to rise. But this is not a reason to exit the bond market. As long as rates are rising for the right reasons (steady growth), it is a good thing for the economy.
We have recommended staying in the short to intermediate term duration target in anticipation of rates moving higher, and feel that our portfolios are well positioned. Rationale for owning fixed income assets remains the same; to provide a dependable level of income and reduce overall portfolio volatility.
Still have questions?
Our team at Chesapeake Wealth Management can help. We welcome the opportunity to answer any questions you may have about wealth management and estate planning. Our team specializes in helping to navigate economic changes and determine the most effective portfolio management strategy – one that’s based on your individual needs and goals.
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*Chesapeake Wealth Management does not provide tax or legal advice. Investors should consult their tax or legal advisor based on their particular situation.