Several recent developments could affect taxpayers relying on a strategy of trading in or holding tax-exempt state and local bonds, commonly known as municipal bonds, or "munis." Munis or muni funds have traditionally been considered a tax-efficient option for low-risk investment, since most are exempt from federal income tax and in many cases state income tax, if issued by the state where a return is filed.
One of these novel developments is a risk of default that only a short time ago seemed unthinkable. Due to tremendous fiscal pressures stemming from the COVID-19 pandemic, beleaguered state and local governments have turned for more assistance to the federal government, where some leaders have publicly suggested those jurisdictions might instead undergo bankruptcy. While that option is not, as of this writing, allowable for states, the enactment of the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA), P.L. 114-187, in 2016 and subsequent restructuring of the territory's debt had been noted even before the pandemic as a possible precedent for the U.S. mainland.
In addition, effects of the legislation known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, on municipal bond investing, while primarily indirect, may nevertheless be significant for many taxpayers, particularly those who, prior to the TCJA, had been subject to the alternative minimum tax (AMT). Other factors include municipal bond ratings agencies' assessments of climate-change risk. Taken together, these developments have created opportunities in some cases and a challenging environment in others for many taxpayers and their advisers. Although the computational aspect of the investing process remains the same — determine the net after-tax returns for comparable municipal and corporate bonds — the increasing complexities of the municipal bond market may make it more difficult to draw conclusions regarding the inherent risks associated with a particular bond issue and whether, in fact, two bonds are "comparable."
THE TCJA's TAX IMPACT
Perhaps the most significant tax-related aspect of the TCJA, with respect to municipal bond investing for noncorporate taxpayers, has been the vast reduction in the number of taxpayers subject to the AMT. According to the Tax Policy Center, the number of individual taxpayers subject to the AMT is estimated to have dropped from 5 million in 2017 to 200,000 in 2018 (see "Fixing the TCJA: How Should Congress Treat the Alternative Minimum Tax?" by Robert McClelland, Tax Policy Center, March 19, 2019). A variety of factors, such as significant increases in the AMT exemption, the elimination of personal exemptions (an addback item under prior law), and the capping of state and local tax deductions, have contributed to the sharp decline in its applicability.
A primary investment opportunity created by the diminished application of the AMT may be an increased viability of private activity bonds, since, generally, interest on "specified private activity bonds" (tax-exempt private activity bonds issued after Aug. 7, 1986, subject to certain exceptions (Sec. 57(a)(5)(C)) is an AMT preference item added to alternative minimum taxable income. In general, private activity bonds are tax-exempt securities (for regular tax purposes) issued by a governmental entity for the benefit or use of a private entity. According to a Congressional Research Service Report ("Private Activity Bonds: An Introduction," Rep't No. RL31457, p. 6, July 13, 2018), private activity bonds paid 50 basis points (0.5%) more than other tax-exempt government bonds. That premium may, however, fall or already have fallen as the markets adapt to the change in the tax environment.
The diminished application of the AMT, specifically with respect to the addback of state and local taxes, may also affect municipal bond investment choices. Under prior law, the AMT provision could often serve as an incentive for many taxpayers to avoid municipal bonds from outside their state of residence. This situation would arise where a taxpayer's residence state exempts its own municipal bond interest but subjects out-of-state interest to the state income tax. With the vastly reduced application of the AMT, however, far fewer taxpayers will have an incentive, for AMT purposes, to avoid investment income that generates state and local income taxes. Nevertheless, the incentive to avoid state and local taxes under the regular tax provisions may often be even stronger, especially for taxpayers whose state and local taxes exceed the TCJA's $10,000 limitation on their deductibility under Sec. 164(b)(6).
MARKET FOR MUNICIPAL BONDS
On the supply side, the TCJA's elimination of the tax exemption for new advance refunding bonds (Sec. 149(d)(1), as amended by the TCJA) eliminated new offerings of these tax-exempt bonds. These bonds, which act similarly to the refinancing of mortgages, where higher-interest-rate debt is replaced with that of a lower rate, had accounted for about one-fifth of new municipal bond offerings (see "Tax Headaches? A Dose of Muni Bonds Might Help," by Carla Fried, The New York Times, April 12, 2019). Overall, as of the end of 2019, the approximately $4 trillion total market for municipal bonds had experienced a slight decline for the year (see "Muni-Bond Shopping Spree Shows No Sign of Stopping," by Heather Gillers, The Wall Street Journal, Jan. 10, 2020).
On the demand side, the TCJA's reduction in the corporate tax rate from a maximum marginal rate of 35% to a flat rate of 21% has made municipal bonds less attractive to corporate investors. As an example, in the commercial banking sector, demand has shifted largely away from tax-exempt municipal bonds to other alternatives, such as asset- and mortgage-backed securities and taxable bonds (see "Shocking Surge: Municipal Bonds Strength Based on Several Fluid Factors," by Chip Barnett, The Bond Buyer, July 1, 2019).
Overall, however, the demand for municipal bond investments has been strong in recent years, as demonstrated by the record $93.19 billion inflow to municipal bond funds in 2019, which easily beat the previous record of $81.06 billion set in 2009 (data per Refinitiv Lipper). Municipal bond investments, as measured by the S&P Municipal Bond Index, were up 7.26% for the 12-month period ending Dec. 31, 2019.
However, in 2020, munis have not been immune from the effects of the COVID-19 pandemic. For the two weeks ending March 25, 2020, investors withdrew nearly $27 billion from muni mutual funds, as state and local governments sold only $6 billion of the $16 billion in bonds they sought to issue between March 9 and March 20 (see "What's Going On in the Municipal Bond Market? And What Is the Fed Doing About It?" by Finn Schuele and Louise Sheiner, Brookings, March 31, 2020).
CLIMATE-CHANGE RISK EMERGES AS A VALUATION FACTOR
Until recently, the risk for bondholders of climate change had typically only been for damages resulting from direct casualties (e.g., hurricanes), which may or may not have arisen from global warming. However, the 2019 purchase by Moody's Corp. of a controlling stake in Four Twenty Seven, a company that measures hazard risks for factors such as extreme rainfall and heat stress, may portend a significant change for both municipal bond issuers and investors (see "Moody's Buys Climate Data Firm, Signaling New Scrutiny of Climate Risks," by Christopher Flavelle, The New York Times, July 24, 2019). This purchase, according to Moody's global head of assessment, Myriam Durand (as quoted in the New York Times article), would allow Moody's to make more precise assessments of climate risk. Such risks were noted to include not only potential costs for remediation of global-warming-related damage but also potential harm to the property tax base where, for example, climate-related factors may make certain areas and properties less desirable for homes.
Further, there is increasing evidence that investment bankers who underwrite the bonds are also considering climate-change risk (see "Muni Bonds Contain New Fine Print: Beware of Climate Change," by Danielle Moran, Bloomberg Businessweek, Nov. 5, 2019). Bloomberg analyzed more than 40 due-diligence statements for coastal Florida bond offerings and found that a majority of them included language regarding climate-change or storm-related risk.
While in the past a bond's rating would likely be reduced only by an actual casualty (e.g., tidal flooding), now a bond can more likely be downgraded simply because a bond rating agency's climate-change experts find an increased level of climate-related risk.
EMERGENCE OF GREEN BONDS
A related development in the climate-change front has been the emergence of what are labeled "green bonds." According to the International Capital Market Association, green bonds are any type of bond instrument where the proceeds are exclusively applied to finance or refinance green bond projects. These bonds, which can also be issued by corporations, are used by governmental entities to implement sustainability and environmental initiatives, with the most common use being for water and wastewater projects.
Currently, the market for municipal green bonds, unlike the vast overall municipal market with more than a million outstanding issues, is dominated by a small number of issuers, with the largest issuer, the New York MTA (Metropolitan Transportation Authority), accounting for 18% by par value of the total volume for the period 2013—2018 (per S&P Ratings Direct). The evidence, according to S&P Global Ratings (March 14, 2019), for any type of "greenium," a premium attributable to green bond status, is "anecdotal and inconsistent." An ongoing challenge for green bond issuers hoping to achieve that "greenium" is that market recognition of "green" status may require the incurrence of significant costs for more detailed disclosures and/or external certification.
2019 PUERTO RICO DEBT RESTRUCTURING
On Sept. 27, 2019, the oversight board created under PROMESA unveiled a plan for restructuring Puerto Rico's debt. The plan's payout structure, which varies significantly from that of traditional bankruptcy plans, could, if it survives court challenge, serve as a model for states such as Illinois and New Jersey that have heavy debt loads (see "$129 Billion Puerto Rico Bankruptcy Plan Could Be Model for States," by Mary Williams Walsh and Karl Russell, The New York Times, Sept. 27, 2019). In the spring of 2020, as the COVID-19 pandemic drained state and local government funds and revenues flagged, Senate Majority Leader Mitch McConnell, R-Ky., said he believed states should be allowed to declare bankruptcy ("McConnell Says States Should Consider Bankruptcy, Rebuffing Calls for Aid," by Carl Hulse, The New York Times, April 22, 2020). Although, under the Bankruptcy Code and U.S. Constitution, states cannot declare bankruptcy, Puerto Rico also, prior to the enactment of PROMESA, could not restructure its debt in bankruptcy-type procedures. Investors and/or prospective investors in state bonds, therefore, should be aware that if Puerto Rico's restructuring serves as precedent for future congressional action, protection against default may not necessarily be as certain as it has been in the past.
Further, Puerto Rico's restructuring is notable not just for the congressional legislation that made it possible but also because of how the oversight board's plan calls for the distribution of assets to its creditors. While, for example, Puerto Rico's constitution places general obligation bondholders well ahead of its pension beneficiaries, the restructuring plan calls for payment reductions averaging 45% for bondholders and no more than 8.5% for retirees.
In consideration of the Puerto Rico restructuring, clients investing in single-state tax-exempt funds (e.g., tax-exempt for California residents) should be reminded or advised that funds of this type often hold Puerto Rico bonds to potentially generate higher income and/or provide diversification and because they are tax-exempt in all 50 states due to Puerto Rico's status as a territory.
FINRA RULE IMPROVES TRANSPARENCY
An ongoing challenge for purchasers of individual municipal bonds has been the relative lack of transparency in the municipal bond sale process. Unlike stocks, municipal bonds do not trade on exchanges, and because the market is so huge — well over a million issues — it may not be possible to definitively determine, for a given day, what is the fair market price for a municipal security. Further, prior to May 14, 2018, broker-dealers were not required to disclose their markups (i.e., the markup amount could be folded into the sales price of the bond), thus exacerbating the risk that an investor would not be paying a fair price for a bond investment.
On May 14, 2018, however, amendments to Financial Industry Regulatory Authority (FINRA) Rule 2232, Customer Confirmations, went into effect that require broker-dealers to disclose a bond's "prevailing market price" (PMP) and the dealer's markup on the sale. The application of these rules, with some significant limitations, may be expected to markedly improve transparency in the municipal bond sales process.
Under the new FINRA requirements, broker-dealers will compute the PMP by reviewing similar trades, if available, of the same security, providing potential purchasers with a more reliable pricing benchmark. If, however, there have not been recent trades of the same security, then broker-dealers are called upon to compute PMP by reference to trades of securities that are similar in terms of factors such as credit rating and yield. However, ambiguity may still remain in the determination of what is a "similar" bond. Other limitations of the FINRA rule include that it does not apply to bonds sold from within a dealer's inventory or to funds sold on the first day of an offering.
REASSESSING MUNIS
Since the passage of the TCJA, demand for municipal bonds has been high, especially among individual investors, as evidenced by the record inflow to municipal market mutual funds. One possible reason is the greatly diminished reach of the AMT, which may have broadened the market for private activity bonds. Another possible reason is the greater clarity and transparency that has arisen in the bond pricing structure following the enactment of FINRA Rule 2232.
However, uncertainty and possible risks for investors are also developing along novel lines. These include the emergence of climate change as a significant credit assessment factor and the COVID-19 pandemic, the latter in the context of the unprecedented Puerto Rico debt restructuring, both of which could have implications for municipal bond markets going forward. As a result, investors seeking after-tax comparisons between equivalent corporate and municipal bonds should be advised that this inherently difficult determination has become even more problematic than in the past.
About the authors
Seth Hammer, CPA, Ph.D., is a professor; Zhen Zhang, CPA, Ph.D., is an assistant professor; and Charles J. Russo, CPA, Ph.D., is an associate professor, all in the Department of Accounting at Towson University in Towson, Md.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.
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