By Amanda Albright
(Bloomberg) -- The rally in the $3.8 trillion municipal-bond market is about to face a major tax-season test.
All year, analysts have credited the $10,000 cap on state and local tax deductions for driving a record-setting amount of cash into tax-exempt debt as investors look for ways to cut what they owe to the federal government. The wave of money helped propel a five-month rally that’s pushed yields on some municipal bonds to the lowest against Treasuries since at least 2001.
But it’s still not clear whether that influx was driven by investors who were sure to face higher tax bills -- or those who just feared they would. Analysts are now watching to see if there’s a pullback after the last tax returns are due on April 15 should the hit be smaller than expected. And there’s also the chance some who are paying more this year will sell bonds to raise cash for their tax bills.
"The demand side has been big," John Mousseau, chief executive officer and president of Cumberland Advisors, said in an interview. "The market is a little bit vulnerable to a backup in yields and a bit of a selloff."
April is usually a difficult time to forecast performance for the municipal market because of the potential impacts of tax-related selling. That’s even more the case this year as investors file for the first time under the 2017 changes enacted by President Donald Trump and congressional Republicans, said Michael Rabuffo, client portfolio manager at GW&K Investment Management. "It’ll be interesting to see how SALT plays out," he said.
The 2017 changes also scaled back the alternative minimum tax, which means some investors living in high-tax areas may be less affected by the cap on state and local deductions than they may have been led to believe. Those who previously fell under the AMT -- which was created to curb the deductions claimed by higher-income households -- could even get a tax break because they can write off up to $10,000 of SALT payments that they couldn’t before.
Peter Block, a managing director at Ramirez & Co., said the 2017 tax code changes remain a wild card. "A lot of people are going to say, ‘It’s not so bad, why am I buying munis?’" At the same time, others may realize they’re now paying more in taxes and seek out the tax-free investments.
Between the two, he said, that may slow the flow of money into municipal-bond funds that’s help drive the market’s gains. But he doesn’t think it’s likely to stop it completely.
--With assistance from Claire Ballentine.To contact the reporter on this story: Amanda Albright in New York at [email protected] To contact the editors responsible for this story: James Crombie at [email protected] William Selway, Michael B. Marois