Fixed-Income Insights
Muni Matters: One Potential Remedy for SALT Shock
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.
A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Lower-rated investments may be subject to greater price volatility than higher-rated investments. A portion of the income derived from a municipal bond may be subject to the alternative minimum tax. Any capital gains realized may be subject to taxation. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Investments in Puerto Rico and other territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.
The information provided is for general informational purposes only. References to any specific securities, sectors or investment themes are for illustrative purposes only and should not be considered an individualized recommendation or personalized investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a reliable indicator of future results.
This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
Tax-Equivalent Yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond. This calculation can be used to fairly compare the yield of a tax-free bond to that of a taxable bond in order to see which bond has a higher applicable yield.
The Thomson Reuters Municipal Market Data (MMD) AAA Curve is a proprietary yield curve that provides the offer-side of “AAA” rated state general obligation bonds, as determined by the MMD analyst team. The “AAA” scale (MMD Scale), is published by Municipal Market Data every day at 3:00 p.m. Eastern standard time, with earlier indications of market movement provided throughout the trading day. The MMD AAA curve represents the MMD analyst team’s opinion of AAA valuation, based on institutional block size ($2 million+) market activity in both the primary and secondary municipal bond market. In the interest of transparency, MMD publishes extensive yield curve assumptions relating to various structural criteria which are used in filtering market information for the purpose of benchmark yield curve creation.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.
The Bloomberg Barclays Municipal Bond Index a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.
The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
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