There is also the new 3.8% Medicare contribution tax on the unearned income of people making $200,000 a year ($250,000 for couples filing a joint return), which is scheduled to roll into effect on January 1, 2013 as part of the health-care reform legislation. Unless the Supreme Court intervenes and strikes the law down, this tax could cause the top marginal tax rate to soar to more than 50% in 2013, making municipal bonds, even at their current low yield, look downright cheap.
Both the expiration of the Bush tax cuts and the implementation of the Medicare contribution tax will occur on January 1 without Congressional intervention (which is unlikely, at least as it appears now).
Some might argue that if these taxes rise, tax-exempt muni bond yields offer a built-in cushion to combat the effect of rising interest rates, at least in some measure. It therefore could be argued that proactively adding municipal bonds to a portfolio would exploit this effect, especially if an investor targeted bonds issued by municipalities with high state income tax rates, where the demand for tax-free income is sure to become especially intense.
Ultimately, though, investing in munis to exploit tax policy can be a risky proposition, especially in these uncertain times. So it is best to consider the merits of muni bonds according to their fundamentals and relative valuation, irrespective of policy. The credit picture is clearer, anyway, as fundamentals are broadly improving. The Rockefeller Institute recently reported that tax revenues increased 3.6% in the fourth quarter of 2011, marking the ninth consecutive quarter of positive year-over-year growth. All tax receipts (property taxes, general sales taxes and individual income taxes) are showing positive growth, underscoring the recovery in the national economy even though notable risks, namely housing and unemployment, remain.
Investing in munis from a valuation perspective is a little trickier. Even though ratios of 10-year muni yields to those of Treasurys remain attractive (they are currently around 97.5% for 10-year bonds), the current municipal yield levels averaging below 2% don't allow much room for returns.
Even so, municipals remain a great alternative for people who would otherwise buy a certificate of deposit or a U.S. Treasury bill, or leave their money in 0% cash. As always within the space, opportunities for larger gains may be available through expert management that will seek out trading inefficiencies and maximize returns via yield curve positioning and income-focused security selection. However, bane or boon, taxes are sure to play a role in driving total return within the space, at least in the near term.
Michelle Knight is chief economist and managing director of fixed income at Silver Bridge (www.silverbridgeadvisors.com), an independent wealth management boutique. All investment advisory services are provided by Silver Bridge Capital Management LLC, a registered investment advisor affiliated with Silver Bridge.