When the Tax Cuts and Jobs Act (TCJA) was nearing passage in 2017, some investors worried that municipal bonds’ tax-free income was at risk. But not only did the TCJA preserve munis’ federal tax-free status, it also made their tax benefits even more attractive to those looking for other ways to reduce their taxable income as a result of the new tax law.
One result is that many existing muni-bond and muni-bond-fund holders have seen the value of their investments increase, while those looking to add munis have been paying more for them.
So, what does this mean for muni investors going forward? Let’s look at what’s shaping the muni landscape and how you can navigate the changes.
A recipe for rising costs
One of the bigger changes to come out of the TCJA was the $10,000 cap placed on the state-and-local-tax (SALT) deduction. (Previously, there was no cap.1) As a result, many taxpayers in high-tax states like California, Illinois, and New York, unable to deduct their full SALT expenses, turned to munis to shield more of their taxable income, thus driving up demand.
At the same time, the TCJA did away with so-called advance refundings—a popular strategy muni issuers used to help reduce borrowing costs—whose elimination may be partly to blame for 2018’s 25% decline in muni issuance2 and could continue to restrict supply.
In spite of low relative yields, investors poured $47 billion into muni-bond funds during the first half of 2019, a record for the first two quarters.3 We expect demand to remain strong—and believe munis continue to make sense for many fixed income investors—for three reasons:
- Even if demand cools somewhat, the realities of the new tax code should continue to drive demand and bolster returns for tax-advantaged munis for the foreseeable future.
- The muni market’s overall credit health remains strong, and issuers should be able to continue making timely interest and principal payments. Indeed, from 1970 through 2017, the default rate among muni issuers was less than 1%—compared with 6.7% for corporate bonds during the same period.4
- Because of their tax-free status, munis may also offer higher after-tax yields than corporate bonds of similar maturity (see “A leg up,” below). That said, individuals in lower tax brackets or those who reside in low-tax states may find better after-tax yields from taxable bonds, including corporates.
A leg up
The higher the federal marginal income tax rate, the more valuable muni bonds’ tax-free income becomes in comparison to corporate bonds and U.S. Treasuries.
Source: Bloomberg Barclays Indices, as of 12/16/2019. Corporate bonds assume an additional 5% state income tax and U.S. Treasuries assume an additional 3.8% surtax for the 32%, 35%, and 37% tax brackets.
If you’re looking to add munis to your portfolio, we suggest keeping three factors in mind:
1. Geographic diversification: Despite a positive credit outlook for the muni market overall, some regional pockets, such as areas of the Rust Belt, suffer from heightened risk. Investors should stick to issuers in economic regions with stable or growing populations, which generally have stronger financials than those in areas experiencing slow growth or outmigration.
Furthermore, it’s generally wise for most investors to diversify across multiple U.S. municipalities. Investors who live in California or New York, however, may want to consider an all in-state portfolio in order to shelter as much income as possible from their state’s high taxes. Both states issue a wide variety of munis each year, making a home-state portfolio fairly easy to implement.
2. Bond classification: Broadly speaking, munis fall into one of two categories:
- General obligation (GO) bonds, which are backed by a specific tax source or the full taxing power of a state or local government.
- Revenue bonds, which are supported by the revenue from a specific project or public service, such as a sports stadium or utilities.
Revenue-bond issuers vary in terms of credit quality and are therefore generally viewed as less secure than issuers of GO bonds, but it’s important to evaluate the risks and benefits of both options. You should ideally look to combine different muni types to build a well-diversified portfolio.
3. Credit rating: Recently, investors have been scooping up hundreds of millions of dollars in munis from lower-rated issuers in the hopes of earning higher yields. Because such bonds have a much higher risk of default than investment-grade issues, we recommend sticking with higher-rated issuers (AA/Aa and above), which comprise about two-thirds of the $3.6 trillion muni market.5
Pick and choose
Munis are a great way to earn competitive yields while protecting income from taxes. Before you join the fray, however, be sure to do your homework and consider the regions and municipalities that make the most sense for your needs and tax situation.
1Prior to the TCJA, taxpayers could deduct either income or sales taxes, plus property taxes. | 2Capital Markets Fact Book, 2019, sifma.org. | 3Britton O’Daly, “Investors Want Municipal Bonds, but Issuance Is Rare,” wsj.com, 07/18/2019. | 4US Municipal Bond Defaults and Recoveries, 1970–2017, moodys.com, 07/31/2018. | 5Gunjan Banerji and Heather Gillers, “Muni-Bond Investors Embrace Higher-Risk Issuers,” wsj.com, 09/21/2019.