With the advent of the Tax Reform Act of 1986, the municipal bond market has undergone significant changes. These changes include the new makeup of buyers and an increase in interest rate volatility.
Prior to the new tax act, municipal bonds were primarly purchased by commercial banks and by households or individuals who purchased tax exempts direct from brokers. The new act made it unattractive for banks to purchase tax exempts, except for issues under $10 million. This sounded the retreat from munis for the banks. According to a report by Morgan Guaranty, commercial banks in 1986 were net sellers of $20 billion of municipals and have continued to reduce their holdings.
Morgan also noted that households reduced their net direct purchases of munis to $4.5 billion in 1986, down from almost $60 billion in 1985. Contributing to the large household purchases in previous years were the huge success in the marketing of unit investment trusts to the public and the higher tax-free yields that were available.
But 1986 was the year of the tax-exempt mutual bond fund. Individuals shifted many of their tax-exempt monies into mutual bond funds. These funds in 1986 were net buyers of $60 billion of municipal bonds. The professional management of the funds, the ability to move from one fund to another in a "family of funds" at no charge, check writing privileges and being able to follow the price of the better-known funds daily in the papers are some of the reasons individuals moved into mutual funds.
Nonfinancial corporations have been attracted to the short end of the municipal market where tax-exempt yields have risen to more attractive levels compared with taxable yields on securities like T-bills and commercial paper. With individuals becoming such a dominant factor in the market, tax-exempt yields have risen compared with taxable yields, as the individual marginal tax rate has declined from 50 percent in 1986 to 38.5 percent in 1987 and to 28 percent in 1988.
At the same time, the marginal tax rate for corporations has declined from 46 percent in 1986 to 40 percent in 1987 and to 34 percent in 1988. As a result, on a relative basis, 3-month tax exempt notes have gone from yielding 64 percent of the average return on 3-month T-bills in 1985 to an average return of 74.8 percent so far in 1987.
Another familiar face in the muni market has returned during the past year: the property and casualty insurance companies. Since these corporations follow the industry's profit cycle, their appetite for munis depends on what phase of that cycle they are in. With profits having increased in 1986 after several years of losses, the property/casualty companies became larger buyers of munis in 1987.
Consequently, with the new cast of muni buyers having different investment objectives and buying bonds in different sectors of the yield curve to meet those objectives; with the marginal tax rates moving lower, and with the supply of new taxfree issues having been sharply curtailed by the new tax law, the volatility in tax exempt interest rates has increased. And in all likelihood, it will continue to do so until all of these factors become assimilated into the changing municipal market.
James E. Lebherz has 28 years' experience in fixed-income investments.