Why the surge in taxable municipal bonds?

Municipal bonds — debt securities issued by state and local governments and some nonprofit institutions — are attractive to investors because interest is generally exempt from federal income taxes. As a result, investors are willing to accept a lower interest rate than they would otherwise charge, and issuers obtain lower borrowing costs. But recently there has been an increase in emissions of taxable municipal bonds, that is, bonds whose interest is taxable to investors. Between January and November 2020, $129.3 billion in taxable bonds were issued (31% of all municipal bonds issued during this period), compared to $67.3 billion in 2019 and $25.1 billion dollars in 2018. Here we explain the tax treatment of municipal bonds and explore what’s behind the recent surge in taxable municipal bonds.

What determines whether interest on a bond is taxable?

Interest on bonds issued by state and local governments is generally exempt from federal tax unless more than 10% of the proceeds are used in commercial or commercial activities by non-governmental entities, including the rental of a public building to a private entity for commercial purposes. use. And nonprofits with 501(c)3 status, including colleges and hospitals, can issue tax-exempt bonds provided no more than 5% of profits are used for unrelated private activities. with the charitable goals of the non-profit organization. Regardless of whether the bond is taxed at the federal level, states independently determine whether to tax municipal bond interest. A 2008 Supreme Court ruling paved the way for states and localities to exempt interest from their own municipal bonds from their own taxes while taxing interest from municipal bonds from other states and localities.

Who issues taxable municipal bonds and why?

In most cases, an issuer pays a higher interest rate to borrow when issuing taxable bonds than tax-exempt bonds. Local governments and nonprofits issue taxable bonds to fund projects that do not meet IRS tax-exempt requirements, such as a sports stadium or student center that has significant dedicated space at a bookstore operated by a national chain and/or a food court or restaurant. In addition, when interest rates are very low (as they are now), the overall benefit of the low interest rate tax exemption to issuers is very small, so entities that may issue tax-exempt bonds may elect to issue taxable bonds to avoid the IRS accounting requirements that accompany the tax exemption.

During the Great Recession, under the American Recovery and Reinvestment Act (ARRA), Congress created new types of taxable municipal bonds and expanded others. Interest on Build America bonds, for example, was taxable to investors, but through a combination of investor tax credits and grants to local governments, the federal government reduced borrowing costs to rates close to tax exemption rates. One of the goals was to expand the market for state and local government bonds to investors, such as pension funds, university endowments, and foreign investors, who typically do not pay federal income tax and do not benefit from the tax exemption. Expanding the market, Build America Bonds proponents say, would make it easier for state and local governments to fund their spending.

What are private activity obligations?

Private Activity Bonds (PABs) use more than 10% of their proceeds for private business activities. While interest on some PABs is taxable, others are eligible for tax exemption as long as their proceeds are used for certain specific (or “qualified”) purposes, such as the construction of airports, docks or wharfs. Interest on non-qualifying PABs is taxable federally, and interest earned on PABs must be included in income when calculating alternative minimum tax (AMT), a tax that applies primarily to income earners. raised.

In addition, the IRS annually sets rules limiting the volume of tax-exempt PABs that can be issued by each state. For 2021, each state can only issue up to $110 per capita or $325 million. Therefore, very expensive projects that would qualify as PAB, such as the construction of a new high-speed intercity train, may also require the issuance of certain taxable bonds.

What fraction of municipal bonds is taxable?

All municipal bonds were tax exempt until the Tax Reform Act 1986 established restrictions on the tax exemption of certain bonds. Between 1986 and 2009, the fraction of taxable municipal bonds remained between 3% and 7% of the total municipal bond market, except for a peak of 10% in 2003, when Illinois issued a taxable bond of $10 billion to meet a pension obligation.

In 2009 and 2010, there was an increase in the issuance of taxable municipal bonds due to the Build America Bonds program, which expired in 2010 and was not extended.

Taxable bond issues jumped again in 2019. From August 2019 to November 2020, between 15% and 40% of municipal bonds issued each month were taxable. In October 2020, borrowers issued $45.2 billion in tax-exempt municipal bonds and $25.1 billion in taxable municipal bonds. (By comparison, corporations issued $152.9 billion worth of bonds over the same period.)

Issuance of taxable and tax-exempt municipal bonds_monthly

Why the jump now?

One of the main reasons is a provision in the Tax Cuts and Jobs Act 2017 which prohibited the use of tax-exempt bonds for prepayment transactions, a refinancing maneuver we describe below. Previously, when interest rates fell, tax-exempt municipal bond issuers could issue a second tax-exempt bond to refinance their debt. Now, entities wishing to use prepayment must issue taxable bonds.

Here’s how it works: Suppose a city issues a tax-exempt bond at a 4% interest rate. A few years later, interest rates drop, and now investors will accept 1.5% on a tax-free bond. Prior to 2017, the city would have issued a second tax-exempt bond and essentially redeemed the remaining portion of the original bond, like a homeowner refinancing a mortgage. In practice, the city takes the proceeds from the second bond and invests the funds in an escrow account. The interest earned on these funds pays the debt service on the first bond issued, and the city’s total borrowing costs go down.

With the Tax Cuts and Jobs Act of 2017, the city can only issue these rollover bonds if they are taxable. However, current interest rates on taxable municipal bonds are so low that the advanced funding maneuver is still attractive. In the second half of 2019, nearly 80% of taxable bonds were used at least in part for this type of refinancing.

Who buys taxable municipal bonds?

For most foreign investors, interest on tax-exempt bonds is taxable in their home country, so they are unlikely to buy them. Tax-exempt bonds are also unattractive for tax-advantaged investments such as IRAs, 401(k), pension funds, and endowments. But taxable municipal bonds, with their higher yield, can be attractive alternatives in these cases.

Taxable municipal bonds may also be more attractive to people in lower tax brackets, for whom the tax exemption is less valuable. Assuming state income tax of 5%, a person in the 22% tax bracket will retain 83% of the interest on a taxable municipal bond; a person in the 35% tax bracket who would also have to pay state income taxes and an additional 3.8% net investment income tax (the Obamacare/ACA tax) will only retain 56 % interests. At current interest rates, someone in a lower income bracket might find the (after-tax) yield of taxable municipal bonds attractive.

What is the history of municipal bond tax exemption?

When Congress introduced a federal income tax in 1861, municipal bond interest was taxed at the same rate as all other income. In 1895, the Supreme Court ruled that the federal income tax was unconstitutional and added that a tax on state and local bond interest would violate the constitutional principle prohibiting the federal government from taxing state activities. 16and The amendment gave Congress the right to impose a federal income tax, which led to the Revenue Act of 1913, the first iteration of the current tax code. This law explicitly excluded interest from municipal bonds in the calculation of income tax. The tax status of municipal bond interest remained largely unchanged until the 1980s, when a series of laws were passed strengthening the regulation of municipal bonds and adding interest back into certain tax calculations for certain high-income earners. This culminated in the 1986 law which defined the PABs. The debate over the allowable volume of tax-exempt bonds has continued to the present day, in part because exempting municipal bond interest from tax calculations reduces federal tax revenue.

What does the future of taxable municipal bonds look like?

If interest rates on taxable municipal bonds remain low, the volume of taxable municipal bond issuance should remain high over the next year. Although the advanced repayment refinance mechanism is usually only profitable once (much like you don’t refinance your mortgage every year), low borrowing costs on taxable municipal bonds can be attractive for projects that are not eligible for tax-exempt financing. – like the student center on a university campus.

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