WASHINGTON — Municipal issuers are already removing direct bank loans from their portfolios in favor of other, more traditional types of debt thanks to the new tax law as well as rising interest rates, analysts said.
The passing of a new federal tax law late last year that reduced the corporate income tax rate from 35% to 21%, as well as the rise in short-term interest rates term have and could continue to incentivize issuers to shun the bank loan market in favor of more traditional borrowing options, Moody’s Investors Service said in a new report. The lead analyst for the report was Jacek Stolarz.
The move away from bank loans represents an almost complete reversal of the trend of recent years, when the floating rate securities market fell sharply and issuers increasingly favored bank loans and private placements.
Between the start of 2010 and the end of 2017, banks’ holdings of municipal loans and bonds more than doubled, from $225 billion to $560 billion, Moody’s pointed out. Over the same period, the amount of variable rate demand municipal bonds backed by bank credit or liquidity facilities increased from $400 billion to $147 billion, in part due to the conversion of backed VRDBs. by banks in direct bank loans.
“Rising short-term rates and widening spreads may push municipal issuers to consider alternatives to bank loans for cost-effective funding,” Moody’s analysts wrote in the report. “Right now, with long-term rates rising more slowly than short-term rates, issuers can convert some of their floating-rate banknotes into long-term fixed-rate bonds to secure relatively attractive rates. Another alternative for issuers looking to maintain flexibility with short-term debt could be floating rate demand bonds.
The adoption of the new tax law is another factor, the rating agency explained.
“Banks are attracted by low default rates from municipal issuers and tax-free interest income,” Moody’s said. “The reduction in the corporate income tax rate from 35% to 21% by the new federal tax law, however, has eroded some of the attractiveness of municipal loans and bonds for bank lenders. Municipal issuers generally paid lower interest rates than corporations, in part because tax-free interest income on municipal bonds was on par with the after-tax yield of corporate loans. With a lower tax rate to be paid by banks, the relative advantage of municipal tax exemption has diminished. As a result, bank loans will be more expensive for issuers.
In addition, many bank loans contain so-called mark-up provisions which, either automatically or at the discretion of the bank, allow banks to raise interest rates on existing loans to reset yields to rates consistent with what they might receive on the taxable market.
Matt Fabian, partner at Municipal Market Analytics, said the swing of the pendulum makes sense. The “universe” of outstanding bank loans remained unchanged in the first quarter of 2018 compared to the last quarter of 2017 according to the Federal Deposit Insurance Corp., Fabian said, indicating that the trend to return to traditional borrowing is already In progress.
“While some bank lenders continue to expand their programs, this fixed number means other banks are letting direct lending back into the traditional market,” Fabian said. “Additionally, year-to-date issuance of floating rate products is up $6 billion, or nearly 50%, from last year and the year before. this is probably an adjustment to life without prepayments, but at least part of it is also a return of old papers placed privately.