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Fixed-Income Insights

With the $10,000 cap on the deduction for state and local taxes poised to boost tax liabilities for many investors, tax-exempt municipal bonds may merit a fresh look.

 

In Brief

  • As investors begin to file their 2018 U.S. tax returns, many may be surprised by the impact of the newly imposed $10,000 limit on deductions for state and local taxes (SALT) on their tax liabilities.
  • Since the SALT limitation is an ongoing feature of the 2017 U.S. tax reform bill, these investors may want to consider alternatives for future tax-free income.
  • As such, a professionally managed portfolio of tax-exempt municipal bonds may be a worthwhile option, given attractive yields versus U.S. Treasuries and strong muni-market fundamentals.

 

As we get further into the first quarter of the current year, more and more people are going to complete their U.S. tax returns for 2018. As they do, they will see the bottom-line impact of the 2017 U.S. tax bill for the first time. Filing tax returns is an annual obligation for a large part of the U.S. population, but the novel aspect this time will be to see the effect on Americans’ tax liabilities of new policies from the 2017 legislation, especially the $10,000 cap on the deduction for state and local taxes (SALT).

In the past, without the cap, many taxpayers were able to have a much bigger deduction. With the limit in place, many of them—especially residents of relatively high-tax states—may see a far smaller refund, or a much higher amount of tax payable, in the final box of their 2018 return. The difference might surprise people and lead them to look for those sources of tax exemption that still exist. This, in turn, might prompt investors to look more closely at municipal bonds, because the interest payments remain federally tax exempt—a key feature of munis that was left unchanged under the 2017 tax bill. Since many potential investors may not have thought about muni bonds in a while, we’d like to review some important points about these tax-exempt securities for those who are considering the asset class. 

1. Credit Quality
Overall, the credit quality of municipal bonds remains strong. Last year, the rating agencies had more upgrades than downgrades on rated muni debt, reflecting their improving opinions of the issuers. Also, based on reports from state governments, tax receipts for many U.S. states—key issuers of general obligation bonds—came in higher, and above budget targets, all around the country. California, for example, has had budget surpluses in recent years, and has been using them to build rainy day funds for times when the economy is not as strong as it is today. 

2. Yields
Recent municipal bond yields have looked attractive compared to other markets.  For example, as of February 6, 2019, the 30-year Thomson Reuters Municipal Market Data (MMD) benchmark yield for AAA-rated bonds was virtually the same yield as a U.S. Treasury bond of identical maturity, even though municipal bonds are federally tax exempt. The 10-year AAA muni yield is more than 80% of similarly dated Treasuries, which also looks attractive when considering tax equivalent yields which gross up the municipal bond yield to reflect the tax advantage. Shorter-dated muni bonds trade at lower ratios to Treasuries, but we believe they retain their appeal for risk-averse investors. 

Those investors taking notice of munis now should also note that yields have risen a lot over the past two and a half years. Since July 2016, yields at all maturities are more than 100 basis points, or 1 full percentage point, higher. When looking at yields on a tax-equivalent basis, the difference is even greater. For those worried about another move higher in rates, and how it might affect their municipal bond investments, we believe they can take comfort in knowing that since the U.S. Federal Reserve started raising rates in December 2015, the total returns of all maturities of the muni-bond indexes compiled by Bloomberg Barclays Indices (through February 6, 2019) have been positive. 

3. Market Conditions
One important thing to note is that the municipal bond market has been performing relatively well thus far in 2019, with the benchmark Bloomberg Barclays Municipal Bond Index posting a modestly positive performance through February 7. In the fourth quarter of 2018, after several quarters of positive fund flows (as measured by Lipper), municipal bond mutual funds had significant outflows.  Instead of performing poorly, the market actually rallied in December as there was strong demand from other buyers apart from muni-bond funds.  So far, during the first several weeks of 2019, municipal bond mutual fund flows have turned notably positive, which we think reflects the attractive relative value currently available in the asset class. 

4. Supply/Demand Dynamics
Looking at one other key driver of the municipal bond market, new issue supply is lower than it was a couple of years ago because of provisions in the 2017 tax bill. The bill eliminated advance refunding bonds, which allowed issuers to refinance their outstanding bonds prior to their call date. Typically, this type of issuance has represented more than one-fifth of the new issue market. This was one of the primary reasons why new issue supply decreased by more than 20% in 2018 compared to the previous year, according to The Bond Buyer. While we believe supply is likely to be slightly higher this year, it is unlikely to get back to previous levels. Another note on outstanding supply is that advanced refunding deals used to create pre-refunded bonds which were the older issues of the bonds being refinanced which now would mature on their call dates.  These bonds represent large portions of short-maturity municipal bond benchmarks. As these bonds now mature, they are not being replaced, so the outstanding amount of short-dated municipal bonds is decreasing, creating more of a supply/demand imbalance for short bonds. 

Summing Up
Some people may be very surprised about having higher tax payments due this year as a result of the 2017 tax bill, particularly in high-tax states such as California and New York. As they look to mitigate the impact of lower SALT deductions on their tax situation, investors may find that municipal bonds may be more interesting because the interest is still federally tax-exempt. As they take a fresh look at the muni-bond market, they may become aware of some attractive features and sources of value. Municipal bonds performed well during the late-year volatility in 2018, and that strength may lend additional appeal to this long-established asset class amid a changing tax landscape. 

 

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