Economic News & Analysis—July 10, 2012

Death, taxes, and nontaxable municipal bonds

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist, and John Manley, CFA, Chief Equity Strategist

Benjamin Franklin famously wrote that few things in life were certain except death and taxes. Thankfully, the tax code provides a way to reduce taxes through investing in nontaxable municipal bonds. Alas, the tax code can’t help much with the death part.

Municipal bonds have been in the headlines lately—and not necessarily for good reasons. Cities like Stockton and Mammoth Lakes, California, have filed for bankruptcy. While there are still few defaults—both in number and dollar amount—in the huge municipal bond market, they can happen and sure do garner headlines. I think these notable bankruptcies underscore why investors should look at investing in mutual funds that offer diversification and use a portfolio management team that conducts top-notch credit research. This helps to avoid the bankruptcies; or, if you don’t avoid them, at least it reduces the impact on your portfolio.

But there is another reason to consider investing in municipal bonds: taxes. Interest income from fully taxable bonds, like corporate bonds, is taxed like income. Under current tax law, top tax rates are scheduled to increase from 35% to 39.6% in 2013. Additionally, many states, and even municipalities, tax interest income as though it is earned income. Furthermore, there’s an additional tax looming. Under the Affordable Care Act—assuming it survives the next election—investment income for taxpayers in the top tax bracket could be subject to an additional 3.8% Medicare tax.

Interest income from U.S. Treasury securities is only taxed at the federal level, so state and local income taxes will not affect interest income on Treasury securities. However, for high-income taxpayers, the new 3.8% Medicare tax may apply to interest income from U.S. Treasury securities. Interest income from nontaxable municipal bonds will be exempt from this new tax, meaning nontaxable municipal bonds could become an even more attractive investment.

Interest income from nontaxable municipal bonds are typically exempt from federal, state, and local taxes, provided the investor resides in the state or locality that issues the bond. This can create a limited pool of investors for certain types of nontaxable municipal bonds. It is typically the highest-income investors that reap the full tax advantage of nontaxable municipal bonds.

When I look at the yields on various types of nontaxable bonds, I think of them as consisting of a few different parts:

  • A risk-free component—the yield on a Treasury security of comparable duration.
  • An adjustment for credit-risk—municipalities can go bankrupt or miss payments, which tends to increase the yield on municipal securities relative to Treasury securities.
  • An adjustment for market liquidity—municipal bonds don’t trade as frequently as Treasury securities, which would tend to increase municipal bond yields relative to Treasuries.
  • The tax-benefit component—this tends to lower the yield on municipal securities relative to Treasury securities. Investors, after all, are concerned about after-tax returns.

The tax-benefit component for the interest earned during a particular tax year is easy to determine when you know what the tax rates are and what your income will be. It gets more difficult to calculate the tax benefit when you hold a nontaxable bond that pays interest in future tax years, mainly because the future tax code is unknown. Tax rates can change, and the taxability of municipal bond interest income can change as well. As a result, changing expectations about future tax rates can affect the yield on municipal bonds. One way to think about the future tax-benefit component of nontaxable municipal bonds is as a form of “tax insurance.” If investors are concerned that future tax rates may increase, especially for the highest-income taxpayers, longer-duration, nontaxable municipal bonds can be extremely attractive.

A historical perspective

Tax rates are scheduled to change at the end of 2012, so how could that affect the municipal bond market? Well, history has a few lessons for us.

In 1992, the top marginal tax rate was 31%. In 1993, the top rate was increased to 39.6%. Shorter-duration municipal bonds, like Bloomberg’s two-year municipal bond index , traded at a yield that was at a 33% discount to the 2-year Treasury note yield in February 1992; then the yield went nearly to parity with the 2-year Treasury in June 1992. By December 1992, the index’s yield had gone to a 31% discount. After the income tax increase went into effect, interest in the tax advantage of municipal bonds waxed and waned but then traded with yields at their biggest discount to Treasuries in November 1993 as investors became more interested. The 20-year municipal bond had a much more stable spread relative to the 20-year Treasury bond, perhaps reflecting the more stable, longer-term view of tax policy going forward due to projected government budget surpluses resulting from the tax increase. 

In 2001, the top income tax rate dropped to 39.1%, fell to 38.6% in 2002, and then tumbled again to 35% in 2003. During those years, there appeared to be seasonality in the behavior of the spreads between municipal bonds and Treasuries, with demand peaking for municipal bonds toward the end of each year. However, as tax rates were lowered, the general trend showed municipal bonds trading closer and closer to the same yield as Treasuries.

In 2011, the top rate was scheduled to revert back to 39.6%, but a compromise was struck between Congress and the president in December 2010 to extend the prevailing tax rate of 35% until the end of 2012. This didn’t seem to affect the municipal bond market considering there were other factors driving the market, like Standard and Poor’s downgrading some municipal bonds (the ones known as “tobacco bonds”) to junk status in November 2010 and a high-profile bank analyst opining on the poor quality of municipal finances.

Although history doesn’t give a clear picture of what could happen, investors might begin to seek nontaxable income in the years to come with income tax rates scheduled to increase, new taxes being created, and concerns about future tax increases to deal with the U.S. federal government’s debt problems. Even though yields on municipal bonds are currently higher than on Treasuries, that pattern is unlikely to persist. Even if Treasury yields increase, municipal bond yields need not move as much, if at all. Ironically, Treasury securities are viewed as “risk-free” securities (because the issuer is incredibly unlikely to default), but municipal bonds might have less interest-rate risk in this environment.

Mutual fund investing involves risks, including the possible loss of principal, and may not be appropriate for all investors. Stock fund values fluctuate in response to the activities of individual companies and general market and economic conditions. Bond fund values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond fund values fall and investors may lose principal value. Funds that concentrate their investments in a single industry may face increased risk of price fluctuation over more diversified funds due to adverse developments within that industry. Foreign investments are especially volatile and can rise or fall dramatically due to differences in the political and economic conditions of the host country. These risks are generally intensified in emerging markets. Smaller- and mid-cap stocks tend to be more volatile and less liquid than those of larger companies. High-yield securities have a greater risk of default and tend to be more volatile than higher-rated debt securities. Consult a fund's prospectus for additional information on these and other risks.

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