The new lower corporate tax rates coming out of tax reform may raise costs for municipal bonds, reports Governing.
First, it’s “not unusual” for loan contracts to include triggers that allow banks to increase interest rates when a corporate tax cut occurs, according to George Smith, a tax attorney specializing in municipal borrowing for Bryant Miller Olive law firm. The trigger may be automatic, or it may require the bank to take action first.
One recent deal Smith closed for a Florida city had a trigger. Under the contract, the city refinanced $23.6 million with a tax-exempt rate of 2.99 percent over 10 years. If the bank’s corporate tax rate is cut, the loan interest rate will shoot up, meaning the city would pay an additional $711,000 in interest costs over the life of the loan.
Additionally, lower rates could make it more expensive to issue bonds on the market (or for local governments to simply borrow money directly from banks). Municipal bonds are currently attractive at lower interest rates to banks and insurance companies because those investors don’t have to pay taxes on the income they earn from the bonds. Same goes for loans banks make directly to state and local governments. But now with corporate income tax rates getting slashed by 40 percent, other investment opportunities become more attractive, because there’s less income tax to pay on those competing investments. Explains Governing:
That means that banks and other corporations will start earning more money off other types of investments because their tax rate is a lot lower. It could even mean that, after taxes, those other investments are more lucrative than the low interest rate muni bonds and loans. The result is that muni rates may have to go up in order to be competitive.
On the bright side, Governing points to the mad rush to issue bonds before the end of calendar 2017, given the adverse impacts of tax reform. This abrupt change is anticipated to decrease demand on some muni bonds in 2018, potentially also decreasing their costs. Also, the cap on the state and local tax deduction may encourage residents in impacted states, like Maryland, to shelter more income in the bonds.
So, at least there’s that.