Municipal bonds (munis) began the year with the headwind that President Trump’s tax cutting and spending proposals could negatively impact the Federal tax-exemption for muni income by reducing or even eliminating it. This risk subsided a bit last week after news came out that the tax plan may not address the muni tax exemption, instead focusing on the federal deductibility of state income tax for individuals and debt interest expense for corporations. Although the plan is still in its infancy and nothing has been agreed upon to date, the tax reform conversation may shift from a headwind for the sector to a tailwind.
The elimination of state tax deductions from Federal income taxes would be particularly expensive for high-income investors, especially in those states with relatively high income tax rates. As a result, high-net-worth investors may allocate more of their assets to munis as other means to limit tax liability diminish. States such as California and New York (two states that President Trump lost in the election), and other high-tax states, may consequently see greater investor demand.
Changes in the tax status of corporate bonds may also bode well for munis. The administration is proposing to reduce the debt interest expense deduction for corporations. If companies are restricted in their ability to deduct interest expense, this may induce them to instead use equity financing or issue debt overseas, thus reducing the supply of U.S. corporate bonds. Less corporate bond supply in the U.S. may lead to higher prices, making muni prices cheaper on a relative-value basis.
We believe munis offer an attractive alternative to corporate bonds at this time and could become even more attractive if the tax reform conversation continues on its current trajectory, though this is far from certain.
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The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.
The economic forecasts set forth in the presentation may not develop as predicted.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.
Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Federally tax free but other state and local taxes may apply.
An increase in interest rates will cause the price of corporate bonds to decline. Corporate bonds are not secured by collateral and are subject to credit risk and default risk.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
This research material has been prepared by LPL Financial LLC.
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