Although the most direct effects of the 2017 federal tax reform have been on tax revenues, the law has also had an impact on the way governments borrow money.

With banks making fewer direct loans to governments, many expected them to turn to the municipal bond market. But that did not happen.

Governments continued to be reluctant to increase their debt, a trend that began after the Great Recession. According to the latest Moody’s Investors Service report, the total net tax debt issued by the 50 states in 2018 was essentially stable for the eighth consecutive year with just $ 523 billion issued. This puts the average annual growth in government debt since 2011 at just 0.6%.

Moody’s said in its analysis that the delay in infrastructure investment has contributed to limited growth in public debt. “State governments remain cautious about issuing bonds,” the report continued, “and increasingly rely on operating revenues to meet their transportation infrastructure needs.”

Due to this calm market, the cost of borrowing has fallen, saving governments millions even as interest rates rise.

Governments have been reluctant to issue municipal bonds in part because officials fear Congress could again meddle in the tax-exempt status of bonds, said Tom Kozlik, analyst at Hilltop Securities. The 2017 law has already eliminated the federal tax-exempt status of prepayment bonds, which effectively killed them. Prepayment bonds allowed governments to refinance their debt earlier and thus take advantage of lower interest rates years earlier.

Koxlik warns Congress will look for other ways to save money this fall, as it will likely face another debate on how to reduce the deficit. “Time may be running out for the municipal bond tax exemption,” he said, “and the repeal of prepayment may be just the beginning.”

Other risky programs

Ksenia Koban, vice president and municipal strategist at investment firm Payden & Rygel, is more concerned that Congress will cut grant or matching fund programs.

State and local governments use the money from these programs in two main ways. They can use the grant money to directly repay the bonds they have issued. Matching funds, on the other hand, provide an incentive for states and localities, as the money raised through bond issuance can be at least partially matched by the federal government.

Municipal bonds are commonly used to finance infrastructure projects. Combined with tax reform, Koban says the uncertainty the federal government’s commitment to infrastructure funding is also creating uncertainty in the municipal bond market. “It definitely changes the landscape,” she says. “We are already seeing a lot more hybrid projects or public-private partnerships as local communities take a step back from traditional types of projects.

Banks bow out

Meanwhile, the 2017 tax law has less incentive for banks to invest in municipal bonds. The law reduced the corporate tax rate from 35% to 21%. This, combined with rising interest rates, has made low-interest municipalities less attractive to banks.

Bank holdings of municipal bonds in 2018 fell by $ 40.9 billion for the year, reports George Friedlander, managing partner of the Court Street Group.

At the same time, direct loans from banks to governments have also declined significantly. Loans reached $ 40.2 billion in 2017, but are expected to total just under $ 7 billion this year.

The seriousness of this development was masked by the lack of investment in the municipal bond market. “The implications of this change would be much greater in a ‘normal’ municipal market, with more total emissions,” Friedlander said.

Low supply, high demand

2018 was one of the slowest years for municipal bond issuance in the past decade. The market has not recovered this year either.

In the first half of this year, government issuers sold more than $ 166 billion in bonds. That’s almost identical to the $ 165 billion sold in mid-2018, according to figures compiled by The bond buyer.

But even though governments don’t issue as many bonds, demand hasn’t changed. In some places, such as California, demand has increased due to the federal tax review cap on state and local tax deductions. Taxpayers are looking to shelter more of their income in municipal bonds.

All of these events have resulted in lower interest rates for governments selling bonds, despite the Federal Open Market Committee increasing interest rates by one percentage point since early 2018.

“There is so much more demand than supply,” Koban says, “the market behaves in a sort of non-intellectual way. It’s just not about assessing uncertainty and risk as it is. must. This shows that there aren’t many other places to go if you’re looking for positive-return, quality-adjusted instruments. “

It appears in the Finance Bulletin. Subscribe for free.