Tax Cut Bill Could Wallop Muni Bond Market

Those governments, primarily in high-tax states like California, Connecticut, New York and New Jersey, would have a difficult time financing services and would have to make big changes, says Zandi, noting that investors in those government bonds would be hurt along with homeowners in those districts.

He explains that home prices in high-tax districts are impacted by the tax deductibility of state and local taxes because people tend to buy as much house as they can on an after-tax basis. If the after-tax affordability of a house declines because of tax changes, those home prices will fall, due to a decline in demand, and that, in turn, would impact the property tax revenues of those districts. And that would increase the credit risks of the muni bonds issued by those districts.

"There is nothing credit positive" for munis in the House or Senate tax bill, says Jane Ridley, senior director in the U.S. Public Finance at S&P Global. She's not expecting a wide range of downgrades but notes that some states and local governments will find it difficult to balance their budgets if tax revenues decline because they will have a harder time raising taxes that are either not deductible or not fully deductible.

Investors and advisors will need to regard each municipal bond issue on a case by case basis, understanding how the final tax bill will impact an issuer's revenues and tax base and how the municipality is addressing those changes, advises Ridley.

Certain segments of the muni bond market will be particularly vulnerable if the final bill includes a provision contained in the House bill that eliminates private activity municipal bonds. "The elimination of tax-exempt PABs…would most directly affect debt issuance for transportation infrastructure issuers," according to an analysis by S&P Global Ratings. The "entire not-for-profit health care sector" would also be adversely affected, according to S&P Global Ratings.

There will likely be changes in the final tax bill before a final vote. The House has passed its bill and as of late Tuesday the Senate bill has made it through the Finance and Budget committees. A full Senate vote could come as early as this Thursday. If the Senate passes its tax cut bill, the horsetrading between the two congressional houses will begin.

— Related: 4 Ways to Get More Mileage Out of Muni Bond Season