How Long Can the Municipal Bond Train Keep Rolling?

Most of us will be paying more in taxes in 2013 and beyond, but have you put pencil to paper yet to calculate what it will mean in actual dollars come tax time next year?

In addition to higher income tax rates, high earners could potentially be subject to an additional 3.80 percent Medicare Surtax on net investment income (Title 26 Internal Revenue Code Section 1411: 3.80 percent tax on the lesser of net investment income or modified adjusted gross income over a predetermined threshold … In other words, check with your accountant).

To avoid any undesirable surprises, it’s important that investors not only understand how the new tax code could impact their portfolio, they must also remain cognizant of potential changes in tax law going forward. 

In the face of higher tax rates for 2013, fixed-income bond managers who build customized bond portfolios have been kept busy by clients seeking out additional tax-exempt income. Strong demand has helped municipal bonds perform well, as of April 30, 2013, the Barclays Municipal Bond Index had returned 5.19 percent over the previous 12 months.

Despite that strength and the challenging rate environment, we continue to see opportunities every day in the muni market for higher tax bracket investors to achieve relatively attractive after-tax yields. Additionally, despite highly publicized warnings of massive credit defaults among municipal bond issuers, state and local finances have improved for the most part.

During the most recent recession, most municipalities were able to cut expenses through lower spending, as revenues from property and sales taxes declined, exhibiting prudent financial management during and after the financial crisis. Now, personal income tax, sales tax, and corporate income tax revenues are all showing growth. With the housing market improving, property tax revenues are rebounding as well, especially in areas of the country that were hit hardest by the housing collapse.

If low interest rates and potential credit issues weren’t enough, municipal bond investors need to be aware that in his 2014 fiscal budget proposal, President Obama calls again for a cap on the value of tax exemptions for interest paid on municipal bonds—to 28 percent, from the current 43.40 percent (the 39.6 percent federal rate plus the 3.8 percent Medicare Surtax).   Individuals earning over $200,000, or couples earning more than $250,000, would be subject to the 28% cap.

For municipal investors in the highest federal tax bracket, this proposal could reduce investment income by 15.4 percent (or $15,400 per $100,000 of tax-exempt income). While it’s difficult to imagine this particular aspect of the 2014 budget could pass unaltered, it certainly can’t be dismissed straight away. After all, this is the third time the president has proposed a cap on municipal bond interest. The 2013 budget and the 2011 American Jobs Act included the proposal, as well.   

Staunch opposition from Republicans is certain. But opposition could come from congressional Democrats and state and local government officials, as well. If passed, the cap would diminish the appeal of municipal bonds for wealthy investors, likely resulting in higher rates and negatively impacting bond values. Additionally, the cap would risk pushing up borrowing costs for bond issuers (and thus, taxpayers) as state and local governments issue bonds to finance capital projects.

Beyond Taxes

Beyond changing tax implications, this remains a particularly challenging environment for investors. U.S. equity markets are at or near all-time highs and U.S. interest rates continue to hover near historic lows. Finding value in this bond market is not impossible, but now more than ever, it is imperative that portfolios are structured to play defense against rising rates. The Defensive Play-book would likely include floating-rate bonds, callable bonds with high coupon rates and trading at a premium (>100 or Par), and reducing the portfolio’s duration (a quick measure of the portfolio’s market value volatility for a given change in interest rates).

So while it feels as though the Fed will keep rates low forever, the reality is, it won’t. It’s not a matter of whether rates will rise, but when. Municipal investors must ask themselves whether or not their fixed income mutual fund or bond manager has the tools in place to combat the negative effects of rising interest rates. Keeping your eye on the changing tax landscape and properly positioning your bond portfolio will be critical in the coming quarters.

Many investors are starting to pre-pare, are you?