With little fanfare, municipal bonds outperformed stocks, commodities, corporate bonds and even U.S. Treasurys last year, averaging a steamy return of more than 10.5%. Though they are no longer the dominant asset class in 2012, municipals have continued to deliver solid results, which is especially impressive given the low absolute level of interest rates. The rates have fallen so sharply that the average yields for high-grade municipal bonds are trading below 2%, their lowest level since the 1960s.
After such a fantastic performance streak in 2011, one has to ponder the current risks to muni bondholders and wonder if there is any upside left for the asset class. Surprisingly, the answer to those questions has more to do with tax legislation than the direction of general market interest rates.
To be sure, with Washington dysfunction at an all-time high, most legislative proposals have had very little effect on the markets, at least up to now. However, if new tax legislation changes become a reality, municipal market investors should be mindful of the consequences the proposed changes could have on their portfolios and have a strategy in place to deal with them.
Consider, for example, President Obama's fiscal 2013 budget, which contains a recycled proposal to cap tax exempt interest on munis at 28% for families with income of more than $250,000. Investors in the maximum 35% tax bracket would end up paying an effective rate of 7% on municipal interest income; this figure rises to 11.6% if the Bush tax cuts are allowed to expire and the highest bracket rate increases to 39.6%.
Certainly these amounts are not inconsequential, especially when one considers that 58% of all tax-exempt interest reported to the IRS comes from individuals with incomes of $200,000 or higher. To put the change into context, if an investor in the 35% tax bracket has $1 million invested at a tax-free yield of 3.5%, that $35,000 in income is equivalent to what would be received after-tax if he owned a corporate bond yielding 5.38% a year. However, if the tax break is capped at 28%, the same bond would yield only $31,590 in after-tax income, or the equivalent of a taxable bond with a 4.86% yield.
Even more of a game-changer is the retroactive nature of the proposed legislation. As written, it would affect not only future issuance but existing bonds as well. Until now, the marketplace has generally operated under the assumption that any changes to the treatment of the municipal tax exemption would not affect previously issued bonds. If that is no longer the case, investors would clearly be prompted to reconsider their allocation between federally taxable and tax-exempt investments, and perhaps make wholesale shifts in strategy.
For sure, the market would demand at least marginally higher municipal yields in order for the asset class to remain competitive with taxable bonds. But even if yields climbed, there may be an overall reduced demand for tax-exempt debt. That would mean higher borrowing costs for state and local governments and in turn less investment in job-producing infrastructure projects on the part of municipalities. For that reason, state and local governments are balking at the proposal, arguing the increased burden will impair the nation's already fragile economic recovery. The Obama administration may believe this burden will be relieved by the additional proposal to reinstate the Build America Bond program, which would allow states and localities to once again sell federally subsidized taxable debt. However, as currently written, the subsidy for Build America Bonds would be cut from 35% to 30% for the next two years before moving down to a less-compelling 28% in perpetuity.
Few Washington observers expect this budget plan to gather enough momentum to pass in its current form, and the muni bond market has ignored the news so far. But investors should get used to the idea that the government will keep putting tax exemption changes on the table as long as it needs to reduce the budget deficit. Tax reform legislation has shaken the market before-in 1986 when Congress passed the Tax Reform Act, giving us our current brackets, and again in 1995 when lawmakers debated the flat tax. But the stakes were not quite as high as they are now with the U.S. debt-to-GDP ratio soaring over the 100% mark.
With so much uncertainty, an action plan for investors is difficult to formulate. Nevertheless, the municipal market will continue to offer high-quality investments with unique tax advantages for those seeking income generation and capital appreciation, and meanwhile efficient markets will allow new pricing levels to emerge amid tax changes and other uncertainties. Even so, it's important to work with a professional manager who understands and effectively arbitrages both the taxable and tax-exempt bond markets. An especially proactive manager might anticipate volatility in this election year by diversifying some of a portfolio's holdings into taxable instruments with break-even after-tax yields similar to those of munis.
But prudence should rule the day in lieu of government action. Nor should investors forget that municipals might actually get a boost from tax legislation, or more specifically the lack thereof, when the so-called Bush tax cuts expire at year's end. Without an intervention, the five income tax brackets (10%, 25%, 28%, 33% and 35%) will increase (to 15%, 28%, 31%, 36% and 39.6%). The maximum long-term capital gains rate is also set to rise to 20% (or 18% on gains from assets held more than five years). Dividends will once again be taxed at ordinary income rates-a whopping 39.6% at the highest level.