Webinar: Is This as Good as it Gets?
Economic Review followed by portfolio strategies.
Good morning, or afternoon, everybody.
I'd like to welcome everyone to the call today.
The topic of our call is, "Is This as Good as It Gets?"
Today, we will present the 2018 Economic Review.
We will discuss current state of the municipal market and look at some different portfolio strategies for everybody.
As I introduce our speakers, you will see three poll questions that will be scrolling down at the bottom of your screen.
We would like for you to answer these questions so that we can all share our view of the economic and tax reform bill.
And we'll do that at the end of the presentation.
I'd also like to share our disclosure with everybody.
It's posted up on the screen.
Now I'd like to introduce our speaker.
KC Matthews is chief investment officer for UMB Bank.
He is responsible for the development, execution, and oversight of UMB's investment strategy.
Kristin Koldol is vice president in the UMB investment banking division, And she's responsible for managing the bank-qualified municipal trading desk.
Tony Quirarte is vice president in UMB's investment banking division.
He is responsible for the management of investment portfolios for our correspondent banks.
And James Carlile is also in UMB's investment banking division, and is responsible for the management investment portfolios for our correspondent bank customers.
Now I'll turn the call over to KC Matthews, chief investment officer, who will share his assessment of the current market and forecast for 2018.
Thank you, Steve.
Well, good afternoon, everyone.
You know, we like to have a little fun with economics.
So we create a theme every quarter.
And a couple of weeks ago, as the year came to an end,
we started to ask the question, is this as good as it gets?
You saw great returns in financial markets.
You saw economic momentum.
The big question now is will that continue?
So we spent a great deal of time looking at numerous economic variables and data, and we came up with seven that we'd like to share with you today.
We call those the Magnificent Seven, and we'll dissect those variables to really make the case that, wait a minute, is this as good as it gets?
No, it could continue.
We could continue to see economic momentum.
We can continue to see positive gains in risk-based assets.
So then I'll conclude my comments with our forecasts, and tell you what we think is going to happen in 2018.
So let's move on to the Magnificent Seven.
Now, this is one of my favorite economic variables, the US Leading Economic Indicators, LEI.
Now, this, of course, is a composite of 10 variables, leading indicators, including hours worked, new orders, housing market building permits, stock market, you name it.
You put on the economic blender and you come up with the LEI.
Now, this is the six-month rate of change.
What's interesting about this variable is it almost has a perfect track record in predicting oncoming recessions.
So as you can see here, that in my red line in my red little bullets there, you can see that when this indicator gets to a minus 3% rate of change, all of a sudden, you see a recession.
Recessions are indicated by the shaded vertical bars.
Now, like I said, almost a perfect track record.
And also, you get a little bit of time before that recession.
So here we are over on the right-hand side at really a plus 3.
So I went back and analyzed how long historically does it take to go from a plus 3 to a minus 3?
And I would suggest that you have at least 12 to 24 months before the oncoming recession.
So answering the question, is this as good as it gets, this indicator would say, no, we can continue to have economic momentum for perhaps the next year or two.
Now, we don't want to look at just one variable.
So we can move on to consumer confidence.
Confidence is very important.
How we feel about things, how you and I feel about things, is important, because almost is consumer consumption.
So when we feel good about things, we consume.
When we don't feel good about things, we sit on our hands and there's no economic activity.
So here's the Conference Board, Consumer Confidence.
And again, if you look at my red dots, the charts are laid out the same.
Vertical shaded areas are periods of recession.
But look at this.
Consumer confidence peaks and turns lower, once again, long before the recession begins.
So over on the right-hand side consumer confidence remains very robust.
There's no sign of consumer confidence rolling over.
And when you think about the drivers of consumer confidence, the labor market, very robust.
Interest rates, even though moving higher, still relatively low.
Stock prices, home prices, energy prices, all supporting consumer confidence.
We feel good about things.
I don't see that change, at least in the next 12 months.
So we can move on to the labor market.
And I mentioned labor market can drive consumer confidence.
When we feel good about our jobs, we feel good about our raises and bonuses, we go out and consume.
So here's the headline unemployment rate, the U3.
And again, we want to look at not the peaks, but the troughs here.
So again, my red dots, you can see that unemployment once again troughs long before the recession begins.
So over on the right-hand side, you see we're at 4.1% headline unemployment rate.
I anticipate that we will see something like a 167,000 jobs created each month, and that will push that unemployment rate lower.
I think, to some degree, we'll get a 3% handle, 3.8%, 3.7%, something like that, throughout 2018.
Now, it's interesting because been associated with inflation.
So if you look at my little green dots there, you can see that way back in the '50s, when unemployment crossed 4%, you had inflation.
And I really want to focus on the period of the '60s.
You can see the next green dot there.
We had a recession in 1960.
Unemployment peaked at about 7%.
Unemployment from 1961 to 1966 went from 7% down under 4%, my green dot there.
And when you think about inflation, during the recovery from '61 to '66, inflation was range-bound between 1% and 2%.
And it wasn't until unemployment crossed 4%, went lower than 4%, inflation didn't move higher.
It spiked higher.
Let me give you an example.
Inflation went from about 2% in 1966 to about 6% in '69.
So the issue today is, will we have a similar situation that, if unemployment continues to go down under 4%, that tells you you're going to have wage pressures and things like that, will we see inflation?
And some inflation is probably good.
Spiking inflation is bad.
Now, I will tell you that I'm in the camp that I don't think we're going to see a runaway inflation for a couple of reasons.
One is, when you think about the structural forces that have kept inflation low for a number of years, those forces have not vanished overnight.
One thing, globalization.
When you think about globalization, that's eroded workers' bargaining powers, as far as wages.
Then you think about automation and technology, artificial intelligence.
All those I think continue to keep wage pressure reduced.
So yes, some of the inflation data that we've seen recently warrants monitoring and investigation.
But again, some of these structural issues, I think, will keep runaway inflation in check, so we don't have the same situation we saw in the '60s.
Now, the next variable I'd look at is really commodities.
And this is verifying the synchronized global growth.
This is just commodity.
Now, if you go back longer-term, commodities have been a long-term structural spiral downwards.
Even from the Great Recession, you can see there in the shaded area, were all over the map.
But really, from can see copper prices have just come down.
It wasn't until last year, all of a sudden, copper prices are up about 30%.
And across the board, base metals, zinc, nickel, etc., all performed very well.
Well, how do we interpret this?
What it tells us is the global growth is still there, because China consumes about 50% of these commodities, driving the price up.
So if we have a continuation of synchronized global growth, commodity prices will continue to move up.
And again, it tells us, is this as good as it gets?
No, I think it can get better, or at least continue on without having that end of the cycle recession in the next 12 to 24 months.
Now, one of my other favorite indicators is the yield curve, because I'm talking to all the experts there.
It's what smart money tells us, the bond market.
And what this is is just a spread between 2's and 10's, with the and then obviously anything negative being inverted.
Now, it's interesting, again, when you look at my red dots, almost every time before a recession, the yield curve becomes inverted.
So it almost has a perfect track record.
And over on the right, you can see that today, we're at about 71 basis points when I looked this morning.
And it's interesting, before we got some inflation scares on Groundhog Day, February 2 of this year, the spread was 58 basis points.
So yield spreads through this correction have actually widened.
So it tells us that if this indicator has a repeat performance, and will accurately tell us when we have a looming recession, we're nowhere near that.
Again, is this as good as it gets?
Well, I think we've got at least another year, and then we'll just have to reassess the data.
I'll turn to the stock market.
I'll talk briefly about the stock market.
The other thing I'll look at is earnings.
And again you can see the trend here, that this is just earnings per share of the S&P 500 Index.
You look at my red dots, earnings peak anywhere from 12 to 24 months prior to a recession.
And so what we're watching there is corporate margins.
If we see inflation, if we see wage inflation, if companies cannot pass on price increases to their consumers, what will happen is you'll see margin erosion.
And that will lead to earnings per share to turn, and we would become more defensive.
Well, over on the right-hand side, you can see where we are today.
Last year, we had about a
I anticipate we get something like another 15% earnings growth on the S&P 500.
And it could be better than that.
Actually, we're conservative.
We're suggesting we get $150 a share earnings on the S&P 500.
The consensus, the street consensus, is 157.
And of course, a lot of that has to do with tax reform.
Of course, corporate America is an incredible beneficiary of that.
So it looks like earnings growth is in play, at least for 2018.
And it's interesting, this correction gave us an opportunity.
Before the correction, the market traded at about 19 and 1/2 times forward earnings, maybe a little overbought.
And then with the correction, the market went down to 10% correction, the market went down to about 17 and 1/2 times earnings.
And I would suggest maybe a little oversold position, given the growth forecasts.
Given where interest rates are, given the economic backdrop,
I think I can make a pretty strong argument that the market, at that level, would be fairly valued.
Now, I mentioned tax reform.
So let me talk a little bit.
A lot of people talk about, tax reform is going to be great for the better for the economy.
Now, I'm not quite in the camp.
I think it would be great for corporate earnings.
But I don't think it'll do that much for the economy.
Now, I'm going to get a little geeky on you here for just a minute, and I apologize.
This is the thing called the fiscal multiplier.
This is data from the CBO, so it's not
KC and his crazy pencil trying to figure this out.
But what it is, the fiscal multiplier says if the government spends $1 through fiscal initiatives, what is the final aggregate spent in the economy?
If the government spends $1, you get the final spend, $2, well, that's a two times multiplier.
Well, this data on the x-axis, down at bottom, it gives you all these different fiscal initiatives.
Purchase of goods and services on the left-hand side.
That's infrastructure spending, buying concrete and steel, building bridges.
And over on the right-hand side in red are, really, tax initiatives.
Reduction of taxes, like we just seen.
Now, it's interesting, on the left-hand side, you can see infrastructure spending
could have the highest potential multiplier, 2 and 1/2 times.
But it could also have a contribution to the economy.
But look over in the red.
All these tax reform initiatives?
Historically, they've never had greater than a one times multiplier.
So this tells me that, clearly, you're not going to get a great economic boost to the economy from tax reform.
It's more about, I think, corporate America, earnings per share, clearly a huge beneficiary of the new tax bill.
All right, I thought just for fun, I'd show you what happens after presidents put their signed tax reform, lower taxes, what happens to the market.
So what I did here is showed you when these past presidents have signed tax reform, lower taxes.
I show you the performance of the stock market S&P 500 a year prior, a year after, and then two years after.
And it's interesting, because typically, the market does well.
You have some external forces.
If you look at Reagan in 1981, you may recall a guy named Paul Volcker.
Of course, Paul Volcker was crushing inflation, runaway inflation, by hiking interest rates.
And lo and behold, you got a double-dip recessionin '81 and '82, and the market was down 23%.
But two years out, it was up 21%.
The same thing with Bush in '01.
You guys remember, we had a recession in '01, and of course we also had 9/11.
So some kind of external forces there.
But then I showed you Trump.
Of course, he signed the bill December 22.
And I recalculated the numbers that, since December 22 to yesterday, the market's up just shy of 1%, 0.83, which is 5.7% annualized return, which isn't all bad.
I think it's realistic.
All right, so they bring it to a close.
Let me show you our forecasts here.
I show you what happened in 2016, 2017.
And then on the right, what we expect to see in 2018.
So you can see a marked improvement in economic activity measured by real GDP, inflation-adjusted GDP,
And I think between
And the risk might be to the upside, because we just got a new budget deal.
And that budget deal includes a lot of government spending, which has not been the case historically.
So I think when you look at that government spend, it could add another 50 basis points on to that as the government spends all this money.
Whether it's on defense or building a wall, whatever the case might be, the government's out there supporting the economy.
Unemployment for the year, I think, will be around 4%.
As I mentioned it, might be lower than that, which will again spook the market to some degree on oncoming inflation.
Fed funds, the Fed told us three hikes.
It depends on market conditions.
I think if you get a more volatile market, the Fed reels it in a little bit, maybe you get two or three hikes, or something between 2% to 2 and 1/4% Fed funds by the end of the year.
A lot of people thought we were crazy in December when we launched these forecasts.
We thought, yeah, the whole curve is going to move up.
We thought we'd see some widening in the spread of 2's to 10s, which has happened.
About 3 and 1/4% by the end of the year.
And of course, we're, what, at 2.90% this morning on the 10-year?
I mean, we might be there by March.
And lastly, the stock market.
As I mentioned, given all this economic data, given tax reform, given earnings,
I do think the stock market will post positive returns.
In December, the beginning of the year, we thought we'd see a 14% total rate of return.
But here we are at
And if we get to 3,000, that's a 10% upside from here, which I think is very realistic, given tax reform and the economic backdrop globally that we're going to experience in 2018.
So that's my snapshot.
That's very good.
What do you think about the volatility?
Do you think we'll continue to see that?
I think it's interesting.
I've been the business for
I still have a lot to learn.
There you go.
But we know in risk-based assets, volatility is just inherent.
And I think the abnormal conditions,
where the last couple of years, where it was absent, it was just too easy to make money.
There's no volatility.
Buy an index fund, and by God, we're never going to see another down day in the market.
Well, we know that's unsustainable.
So prior to Groundhog Day and the correction we had, typically, happen every 10 weeks.
We were on the Week 80 without a 5% correction.
So yeah, we're back to normal.
We're going to have volatile markets.
We're going to get all kinds of disruptors in the market, whether it be inflation scares, military scares.
Whatever the case might be, volatility is back and that's normal.
Thank you very much.
I enjoyed your presentation.
Now let's move our focus to the municipal market.
It has been a very interesting start of the new year for municipal bonds.
December finished strong as the tax reform legislation took center stage.
The tax reform bill pushed the timeline up for issuers to market their bonds, fearing that the private activity bonds in advanced refunding bonds could be eliminated as early as January 1st.
Although the private activity bonds were not eliminated, the advanced refunding bonds were eliminated.
As a result, as you can see in this graph, many issuers took advantage of the lower interest rate environment and brought approximately $26 and 1/2 billion in new municipal issuance to market during the month of December, making
December an all-time single month record for municipal issuance.
Typically, January supply is low.
But as a result of the tax reform,
January's new issuance was even lower.
You can see that the January issuance ends in 2018 was the lowest issuance for the past seven years.
The last time a similar slump in supply from municipals occurred was after the major 1986 Tax Reform Act became effective.
The low volume and uncertainty in the market has made bidding on new issues very difficult, as buyer's work to digest this new tax law and its effect on their businesses going forward.
For AA credit, general obligation, bank-qualified bond, new issue, I am seeing up to 10 or more bidders, with the average rate difference ranging up to 35 basis points.
This is a true indication that participants have wavering interests, although there are still buyers that are out there buying bonds, municipal bonds.
This is because of the credit quality, low default rate, and diversification opportunities municipal bonds provide.
They still make sense at the right entry points.
I personally like municipal bonds as an asset class.
Looking forward, analysts are expecting supplies to remain down approximately in the first quarter versus the same period last year.
As a consequence of tax reform and increased taxes on individuals in high-tax states,
I believe demand for municipal bonds will still remain strong in 2018.
Demand should increase for both the bond funds, as well as these individual buyers.
And we continue to have new people, new buyers, enter this space in a mood to diversify their higher-quality, larger-name credit.
Retail investors at large have not yet been aggressive buyers this year as they were at the end of 2017, perhaps with the expectation that higher rates are on the horizon, like most of everyone is anticipating.
However, for those states with high taxes, we expect retail investors will still look to municipal bonds not only for diversification, but also as one of the few tax-exempt investment opportunities left to them.
Gradually, as both buyers and borrowers adjust to the new rules and new opportunities, the market will eventually adjust as it did after 1986, when new supply records originated in subsequent years.
Now I will turn it over to Tony.
Kristen, before we move on, Tony, before we move on,
I think we all understand the supply/demand issues that happened in January.
But you mentioned something that's really interesting to me.
You've been underwriting bonds for many years, and you mentioned that now on the competitive side, you're seeing maybe the same amount of people bidding, but spreads widening?
What, traditionally, have you seen, when you underwrite, the spread to be when you do a competitive bid?
I mean, historically, you're seeing spreads up to maybe 10, on a AA GO credit.
And I think that this bigger spread of 35 basis points is just that uncertainty of buyers that banks are sitting on the sidelines and companies are sitting on the sidelines.
We're all expecting higher interest rates.
And there's just that uncertainty that we're all not really sure where this is going.
So that's 2 and 1/2 times the spread that you'd normally seen.
So there's a lot of unsurety in the market right now with the dealers and the customers.
Until that changes, we won't get the spreads in the right position.
Is that the way you see it?
Thank you, Steve.
From my perspective, one of the more striking legislative feats occurred this past November, when the GOP unveiled their tax reform proposal.
In a matter of weeks, both houses of Congress passed the first significant tax reform legislation in over 30 years.
This remarkable legislative feat contrasts to the 1986 tax reform legislation, which took years to enact.
And now for the takeaways for the tax law.
The new law begins with a significant corporate income tax cut from 35% rate to
What's surprising is the size of the tax rate cut.
Some analysts estimate that, for every percentage point cut in the corporate tax rate, the treasury could experience $100 billion of lost revenue over the next decade.
Based upon this assumption in extrapolating the 14 percentage points cut, this would represent about $1.4 trillion in lost revenue over a decade.
I should note, this particular estimate is predicated upon the static analysis, and not dynamic scoring.
To overcome that shortfall in treasury revenue, the new law repeals, as noted by Kristin, advanced refunding.
This component represents a significant 40% for all municipal issuance.
The repeal will have a material impact on municipal issuance going forward, with the inability to refinance debt at lower rates.
There is, however, one bright spot.
With the elimination of the advanced refundings, we should see fewer municipal bonds being exercised.
Also, limited in the new law was the tax credit and the direct pay bonds, which is a relatively small segment within the municipal market.
And surprisingly, private activity bonds was not repealed by the new tax law.
This feature alone was likely left, so as to keep the ability to fund future infrastructure projects, like airports, hospitals, stadiums, convention centers, which is a topic of interest today.
Now, to offset some of the corporate tax and income tax rate cuts, the new plan calls for the reduction in the SALT, state and local taxes, to a deduction of $10,000 in 2018.
This item alone is estimated to generate $1.2 billion in treasury revenue over the next 10 years.
On the next page, we wanted to highlight the shape of the yield curves for both the taxable and the BQ securities for all of 2017.
This period covers 13 months, ending January 31, 2018.
The blue line is the taxable yield curve for the most recent or current period.
At the two-year part of the curve, you could see a 2.42% yield, while the 10-year prints a 3.25% yield, thus generating a taxable 2-10 spread at 83 basis points.
The second line, in red, shows the taxable yield curve from a year ago.
This particular curve shows a two-year taxable yield up 1.77% while the 10-year taxable yield was slightly below 3.25% resulting in a 2-10 spread of approximately 148 basis points.
The next set of graphs is the bank-qualified yield curve for both the current and the year ago period.
The BQ curve is in green, and it's the most current reading.
At the two-year part of the curve, you'll see that that's just slightly below the taxable yield of yield, while the is 2.58% resulting in the spread of 86 basis points, which is about three basis points higher than the taxable 2-10 curve was earlier shown.
As you could imagine, the last curve is the prior year's BQ curve, represented in gold.
This curve is remarkably similar in slope when compared to the current BQ curve, with the 2's at 1.48% and the 10's at 2.50%, resulting as spread of 102 basis points.
The takeaway from both curves illustrates a taxable curve pretty much follow the pattern found in the [INAUDIBLE] curve changes in 2017, while the BQ curve over the same period remained relatively unchanged.
This is likely due to strong BQ demand and limited supply in 2017, which kept BQ yields in check, and in spite of the run-up in treasury yields, limited the volatility in market prices for such securities.
For 2018, we anticipate the BQ's supply will be similar at best, if not lower, to our experience in 2017.
For a relative value discussion, a bottom half of this graph addresses the spread between the taxable and the BQ securities, spread out across the term structure out to 15 years.
At the two-year point, you'll see the spread is 70 beats, and then gradually increases through the six-year maturity term, with a spread of 87 basis points.
Thereafter, the curve then, the current curve spread then tightens back to 67 basis points at the 10-year point, and then ultimately lower to 46 basis points at the 15-year tenor.
This illustrates the optimum spread can be found at the five- and six-year tenor, with the respective 85 and 87 basis points.
And finally, the green bar shows the prior year's taxable BQ spread at the respective tenors.
Dissimilar to the current year's taxable to BQ spread, the prior year spread steadily increases through the current structure, with spreads of 35 basis points of the two-year, and then ultimately reaching 70 basis points at the 10- and 15-year.
In summary, history suggests, as happened back in 2004, when the Fed embarks on a gradual tightening policy, municipal bonds tend to outperform treasuries
where municipal bond prices declined less on a relative basis of treasury securities.
And we could see that demonstrated on the BQ curves for the current and the prior period.
Looking forward for the lack of municipal supply with the prospect of both fed rate hikes and curve flattening, then it's reasonable to assume that municipal securities would outperform treasuries again.
To illustrate the tax law effect upon future investment decisions, the following table presented by James Carlyle will show the yield variance between taxable yields and BQ tax equivalent returns, using either the C-corp or the assumed S-corp rates.
There's little doubt investment managers would need to further evaluate the investment merits between tax exempt versus taxable municipal securities.
Thank you, Tony.
Before you go, James, let me point out something.
On the bottom of your chart here, it's interesting.
If you think municipals are a good asset class, which we do believe, it depends on what your tax rate is.
But there's still value to be made in either taxable or tax-exempt.
So on the short end of the curve, the taxable munis are of value.
And after you hit that ten-year, the BQ tax-exempt munis offer some value.
So depending on where your institution is and what tax rates you are, municipals can be still a good buy, even if you're short or long.
Absolutely And that is absolutely correct, that the longer in, it's a favorable market for municipal investors.
Another option to consider, too, is with the lower yields found on the taxable spreads at the two, three, and four-year part of the curve.
These are great vehicles to help build interim ladders and liquidity ladders, so you have good demand for both the long-term investor, as well as the intermediate to short investor.
That's awesome, because if you like the credit, you like municipals, you can still be a player.
Even on a short or a long end, get value out of it.
So I first want to go ahead and set the stage for what we are looking at on this slide, just to make
sure we're all tracking.
What we wanted to explore is what do the yield curves show us regarding the tax consequences of our investments a year ago versus today?
So what we did is we used the January 31st as the end of period benchmark, because it's timely to our current analysis.
And perhaps more importantly, if you go back one year to January of 2017, tax reform wasn't really on anybody's minds.
It wasn't yet a tangible political topic or possibility.
So it's pretty safe to say that it was mostly absent from curve mechanics and investment consideration.
So it's a very relevant benchmark time.
So starting at the last column, you can see the primary tenor points we plotted for both 2017 and 2018.
And what you're looking at in the second and third columns are the yields for those curve points for both the Bloomberg
AA BQ GO and the Bloomberg AA Taxable GO curves.
Again, that's the Bloomberg AA BQ,
Bloomberg AA taxable, both GOs.
The idea was to keep the comparison parity as close as we can using the two generic AA GO curves.
And the last piece I want to go ahead and explain, before making our illustration, is the rationale we used for our assumed tax rates.
So for C-corps, course was pretty cut and dry.
Our historical default rate was 34%, reflecting that federal C-corp rate.
But moving forward, 21% will be the assume rate, until we're told otherwise.
So for S-corps, it's a bit murkier.
But historically, we've used an assumed rate of around 30%.
But we chose to keep this rate for our current analysis.
The general assumption right now is that the tax implications for a higher personal income bracket,
once adjusting for changes in deductions, such as SALT deductions that Tony alluded to, is going to be about the same overall.
So it made sense for us to leave the S-corp rate unchanged at our 30% assumption.
So if you look at the column matters that reflect the tax rates we applied for analysis, you'll see them just as I explained for the corresponding taxes and incorporation types.
Now, as we head right on our columns, here's where we start looking at how the decision to invest in an exempt or a taxable muni has different implications moving forward this year compared to last.
And those outcomes appear very different on the surface, depending on whether you're in an C-corp or an S-corp bank.
So let's use the five-year maturity to illustrate our point and make sure we're all on the same page here.
If you go to the lower half of this slide representing the 2017 curves, you'll see that as of January 31st, the BQ AA GO curve was at a 1.86%, and the untaxable AA GO curve was at a 2.54%.
So by applying our assumed tax rates of 34% for C-corps, and again 30% for S-corps, the curve trade
suggests the C-corp tax equivalent yield was 2.82%, and for S-corps, it was 2.66%.
For either bank type, your tax equivalent yield on the BQ muni was higher than the equivalent taxable.
And this is represented by the differentials in the last two columns to the right columns.
And those last two columns are simply illustrating the tax-equivalent basis point pickup in yield against the taxable muni.
So now, let's pop up to the top of the page and do the same comparison.
Still looking at the five-year tenor as of January 31, 2018, the AA BQ GO curve was at a 2.05%, and the taxable AA GO curve was at 2.87%.
So for the C-corp now at a 21% tax rate, the tax equivalent yield is 2.59%, and the S-corp tax equivalent yield is at a 2.93%.
So now, we have a different story.
For the S-corp at the BQ muni is still the better option, as the 2.9% tax equivalent yield outpaces the taxable yield by six basis points.
And that's what that far-right differential column is showing.
For the C-corp at 21%, perhaps not so much anymore.
The tax equivalent yield of 2.5% represents a negative 28 basis point differential against the taxable muni, shown in red in the second column from right, suggesting that taxable security's a better choice compared to the exempt bond by quite a bit, in fact.
And this assumption holds true for C-corps, through all the tenors we tested, until you get out to 10 years, when the exempt security then becomes profitable again, based on those curve dynamics, which just really reflects the flatness in the longer tenors
All the figures in red represent where, for a C-corp, you might be at a disadvantage with exempt munis, based on this example.
So for S-corps, I would suggest exempt, bank-qualified bonds are still a great choice, as your tax equivalent yield, based on our assumptions, will still outpace the taxable security.
For C-corps, unless you're buying everything further, it's probably warranted you take a hard look at this and really examine, based on your personal tax situation-- by personal,
I mean your banks or your pass-through shareholders if you're an S-corp, if and where it makes sense to focus on taxable securities, rather than exempt that you probably focused on the past.
Now, we know the assumptions have limitations.
We're testing one rating bucket with the AA, one repayment type with the GOs and we felt this was a very good baseline to keep things simple and illustrative.
But that said, we know you likely buy bonds off these narrow assumptions, and we certainly know that each bank tax situation, whether S- or C-, could be quite different from our assumptions, and probably is.
Well, we could easily perform this analysis for any specific scenario you want want to test regarding bond ratings, GOs versus revs, and of course, and probably most importantly, your bank's specific tax situation.
As you've heard, as echoed throughout the presentation,
we still like munis.
We still think they're a great value, a great credit.
We just really encourage you to get with your representative here at UMB.
Take a look at your portfolio.
Examine if you're buying mix, moving forward, might need a look, or even if, perhaps, there are existing holdings that might serve your bank better if replaced with a more tax-appropriate security to your situation.
Historically, whether S- or C-corp, you could pretty much buy a bank-qualified bond and know that the tax equivalent yield you're getting is likely better, based on that tax treatment.
Moving forward, doesn't appear to be the case, at least on current circumstances as we understand them.
So definitely let us know if we can help apply this analysis, take a look, see if there are better alternatives for you.
In wrapping up, I'd say we've made the case that municipal bonds are still a good asset class.
And at this time, you would need to really probably sit down and talk with your tax accountant or your tax attorney, and figure out where your bank tax rates are.
And then sit down with your UMB rep and decide where you want to buy and which municipal class you need to buy in based on those rates.
KC, thanks for your overview.
I think it's time to take a look at our questions and see how everybody else feels out there.
All right, now to review the poll questions for you as you think of your questions.
Because there's a lot of data that we went over, and I'm sure everybody would have a question.
On the first question, we asked you, do you think the slope of the yield curve will flatten?
Well, it looks like, what, 64% said yes.
So I think that would--
KC, that's kind of where-- is that where you're at?
Yeah, I guess it depends on the time frame in the next question, right?
I guess we should've said this year.
Is that is what you're thinking?
Yeah, I think that's right.
I think the curve will flatten at some point in time, just because we're getting closer and closer to the end of the economic cycle.
Second question, with the tax reform, how likely are you to maintain the volume of your municipal portfolio?
It looks like everybody is agreeing with us, that municipal bonds are still good value.
At least 75%
That's great for us to know.
We believe it depends on your tax rate, and you'll have to look at that very closely.
But we're prepared and we think that's a good solution.
Third question, how likely are you to transition from tax-exempt to taxable municipals?
So everybody-- yeah, less likely is the majority.
And there are some that are considering that.
And I guess it all depends on where you are, C-corp or an S-corp, and what you want to do going forward.
But it looks like most people believe that that's an asset class they want to stay in.
And I think that was our conclusion also.
So now, let's see if there's any questions.
So we have one question.
"Is a recommendation to focus on the 10-year plus municipal bonds?"
Well, I think whoever wrote that got the point of our presentation.
We do believe there's good value to be had in BQ municipal bonds out 10 years.
Is that what you guys all believe?
And I think just to illustrate the point, because we did talk about that 10-year and longer tenors being the inflection point where the exempt bond makes better sense.
We're not suggesting that you should necessarily deviate from the investment policies and comfort levels that have historically made sense for your bank.
It's just a matter of that's the curve trade as they currently exist.
What we do really encourage is that if, let's say, you like A-rated essential service revs and you're a C-corp that currently would see-- maybe you're less, or maybe you have a 15% tax rate after all is said and done.
We can model that wherever you like to buy historically and, wherever it's made sense for your bank's liquidity and maturity features.
So that's really the point.
We're not necessarily saying that longer munis are better than shorter munis.
We're just saying that, based on your personal situation, let's really take a good, hard look at what does make sense once you have those factors dialed in and we can really apply the correct math to the analysis.
Well, and to your point, James, I think you're right.
If you think the curve is going flatten and you want to shorten it a little bit, you can still be in municipal bonds.
But you might look at taxable munis on the shorter end as the curve flatlines.
Well, thank you.
We'd like to thank everyone who attended our presentation today, and I hope you found it of value.
And please give us a call if you have any further questions.
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