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Will a Tax Cut Take the Shine Off Muni Bond Funds?

Tirthankar Chakraborty

Municipal bond funds are likely to remain attractive compared to other investment grade fixed income bonds, even if the Trump administration lowers the top tax rate bracket as per Goldman Sachs Group Inc GS. Municipal bond funds, historically, have not only survived but also flourished in a lower-tax environment, especially, if we look back on the Ronald Regan era. To top it, if tax rates are slashed, it will create buying opportunities as muni bond yields seem attractive, even after factoring in lower tax rates.

What Makes Munis Attractive?

The advantages of investing in municipal bonds can be summed up in two words: tax free. Even though interest rates on municipal bonds are lower compared to long-term securities like Treasury bills and CDs, it’s the tax advantage that gives them the level playing field.

For instance, if you are in the 25% tax bracket, you have to find a taxable security that gives an interest of 4% to match a tax-free municipal bond with an interest rate of 3%.  In other words, if you invest $5000 in a bond, you will earn the same with a 4% taxable bond like a 3% tax-free municipal bond. The gap between taxable and tax-free municipal bonds widens with higher income tax brackets. You will find that in the 35% tax bracket, you need a 4.62% taxable interest rate to yield the same amount as that of a 3% municipal bond.

Some taxpayers, depending on where they reside, have to pay state and local income taxes. But, in case of municipal bond funds, interest income earned are exempted from federal taxes and in many cases from state taxes as well. The second major advantage of having municipal bonds is that they are incredibly safe. From 1970 and 2000, the 10-year cumulative default rate for municipal bonds was a meagre 0.04%. In other words, in a 30-year span, less than half of 1% of municipal bonds failed yield the promised interest and principal.

Will Lower Taxes Affect Municipal Bonds?

Goldman – Munis Still Attractive Even If Top Tax Rate Falls

But, what happens to municipal bonds if the marginal tax bracket comes down. The last time tax rates came down was during Ronald Regan’s presidency. Tax rates for the highest marginal tax bracket were lowered during his administration to 28% from 50%. A sensible deduction would be that lower taxes signify less demand for the tax-exempted municipal bonds. However, that wasn’t the case, with municipal tax-exempt money market funds and municipal tax-exempt bond funds witnessing considerable growth throughout the 1980s. In fact, assets under management in the muni space scaled from around $300 billion to $1 trillion.

The question is whether these bonds will be able to maintain the solid demand trend this time around? After all, to some degree, we could experience a similar tax cut under the Trump regime in the coming months. According to Goldman Sachs, municipal bonds remain attractive even with lower top tax rate. If the top tax bracket drops from the current 43.3% to 33%, muni yields will fall from 5% to 4%. That’s still above the 3% rate of investment grade corporates, 2% for agency mortgage-backed securities, and 1.5% for Treasurys.

Marginal Tax Rate Cut Will Create Buying Opportunities

Further, even if we assume that cutting marginal tax rates will deal a blow to munis, it will create buying opportunities for investors by benefitting from the selloff. And why not? For the long run, these bonds do offer safety of principal, low volatility and high return.

Sean Carney, who heads municipal strategy at BlackRock, Inc BLK, said that investors are already using muni exchange-traded funds such as iShares National Muni Bond ETF MUB to buy on weakness and sell on strength. The benchmark tracking MUB is up 0.8% on a year-to-date basis and has a 2.3% current yield. The Eaton Vance Municipal Income Trust EVN is already selling at a discount, when it usually commands a premium. It yields 5.53%.

What about investors who don’t want to trade? Its makes sense for them to invest in actively managed funds like Nuveen Inflation Protected Municipal Bond Fund NITAX. This fund was a top performer in its category last year, gaining 3.3%. It’s particularly known for hedging against interest-rate risk. Nuveen All-American Municipal Bond Fund Class A FLAAX, the firm’s traditional muni offering, has given a 4.9% average annual return in the past 10 years, putting it in the top 2% of all national long-term muni funds. 

In fact, through the end of this February, the top performing muni sub-sectors were 30-year high yield munis and 5-year triple Bs, while the worst performers were 10-year triple-As.

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