If Tax Rates Go Down, There’s Still an Upside to Munis

by: , Chief Portfolio Strategist, MainStay Investments

While it’s early days, President-Elect Donald Trump has indicated his intention to lower tax rates for top earners–his plan during the campaign called for lowering taxes with the rate for top earnings declining from 39.6% to 33%. So what might this mean for municipal bond investors? We caught up with MacKay Municipal Managers’ John Loffredo, who manages MainStay’s Municipal Bond Funds, to get his take.

According to John, municipal bonds still offer a lot of value, and are not discounting the benefit of their full tax exemption. The team believes this provides some cushion in the event of lower income tax rates or higher Treasury yields. As you can see in Figure 1, at a 33% tax rate, investors would have to generate taxable yields upwards of 5% in order to get the tax equivalent yield of 3.5% on municipal bonds—not easy in today’s low rate environment.

Figure 1: Even at Lower Tax Brackets, Municipal Bonds Generate Attractive After-Tax Yields

2015 Federal
Income Tax Rate
Tax-Equivalent Yields
3.50% 4.00% 4.50% 5.00%
25.00% 4.67% 5.33% 6.00% 6.67%
28.00% 4.86% 5.56% 6.25% 6.94%
33.00% 5.22% 5.97% 6.72% 7.46%

Rates are hypothetical, not guaranteed, and not representative of any specific investment. Past Performance is not indicative of future results. The Federal Income tax rates are based on published rates in effect as of January 2015. Actual tax rates will vary depending on the investor’s income, investments, and deductions. The tax information shown is current but subject to change. These calculations are for illustrative purposes only and are not intended to predict or depict any fund’s performance.

John discussed municipal bond market volatility in October and particularly since the election, and the fact that this may actually lead to opportunities for skilled active managers. John stated that some price moves that don’t properly reflect the fundamentals may create opportunities. As you can see from Figure 2, investors who have taken advantage of volatility in the past have been rewarded in periods following cycles of market stress. Past performance is no guarantee of future results. Furthermore, liquid portfolios tend to be more greatly impacted by a sell off, but may have the potential to recover faster given that cash can be deployed quickly to take advantage of mispricings in the market.

Figure 2: Both Investment Grade and High Yield Municipal Bonds Have Historically Done Very Well Post Periods of Stress

Source: Barclays 11/22/16. Past performance is no guarantee of future results, which will vary. Post FC refers to Post Financial Crisis. Meredith Whitney is a financial analyst. The column “Meredith Whitney” refers to the period covering her 2010 interview on the CBS program 60 Minutes, in which she said that she expected that 50 to 100 counties, cities, and towns in the U.S. would have “significant” municipal bond defaults within the next 12 months. Post MW refers to the period after Whitney made her remarks. Fed/Detroit refers to the City of Detroit’s bankruptcy filing. Post F/D refers to the period after the filing. Bloomberg Barclays Municipal Bond Index is an unmanaged index that includes approximately 15,000 municipal bonds, rated Baa or better by Moody’s, with a maturity of at least two years. The Bloomberg Barclays High Yield Municipal Index is an unmanaged index that includes the universe of fixed rate, non investment-grade debt. Bloomberg Barclays U.S. Treasury 5-7 Year Index measures the performance of government bonds issued by the U.S. Treasury with maturities of 5-7 years. It is not possible to invest directly into an index.

Right now there are still a lot of unknowns in terms of the new administration. Once policies are more clearly vetted, the team believes technical factors should improve significantly. In the meantime, investors should focus on the long term and the attractive income that municipal bonds provide. Prices go up and down, but the MacKay Municipal Managers team has expertise navigating these markets and the potential to unlock additional value associated with these price movements.

Municipal securities risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future legislative changes which could affect the market for and value of municipal securities. These risks include: (i) general obligation bonds risk—timely payments depend on the issuer’s credit quality, ability to raise tax revenues and ability to maintain an adequate tax base; (ii) revenue bonds (including Industrial Development Bonds) Risk—these payments depend on the money earned by the particular facility or class of facilities, or the amount of revenues derived from another source, and may be negatively impacted by the general credit of the user of the facility; (iii) private activity bonds risk—municipalities and other public authorities issue private activity bonds to finance development of industrial facilities for use by a private enterprise. The private enterprise pays the principal and interest on the bond, and the issuer does not pledge its full faith, credit and taxing power for repayment; (iv) moral obligation bonds risk—moral obligation bonds are generally issued by special purpose public authorities of a state or municipality. If the issuer is unable to meet its obligations, repayment of these bonds becomes a moral commitment, but not a legal obligation, of the state or municipality; (v) municipal notes risk— municipal notes are shorter-term municipal debt obligations that pay interest that is, in the opinion of bond counsel, generally excludable from gross income for Federal income tax purposes (except that the interest may be includable in taxable income for purposes of the Federal alternative minimum tax) and thathave a maturity that is generally one year or less. If there is a shortfall in the anticipated proceeds, the notes may not be fully repaid and the Fund may lose money; and (vi) municipal lease obligations risk—in a municipal lease obligation, the issuer agrees to make payments when due on the lease obligation. Although the issuer does not pledge its unlimited taxing power for payment of the lease obligation, the lease obligation is secured by the leased property. As interest rates rise, the prices of bonds fall.

There is no assurance that the investment objectives can be met. It is not possible to invest directly in an index. All investments are subject to market risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market.

For more information about MainStay Funds®, call 800-MAINSTAY (624-6782) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing.

The Bloomberg Barclays Municipal Bond Index is an unmanaged index that includes approximately 15,000 municipal bonds, rated Baa or better by Moody’s, with a maturity of at least two years.

The Bloomberg Barclays High Yield Municipal Index is an unmanaged index that includes the universe of fixed rate, non-investment grade debt.

Bloomberg Barclays U.S. Treasury 5-7 Year Index measures the performance of government bonds issued by the U.S. Treasury with maturities of 5-7 years.

MacKay Shields LLC is a federally registered investment advisor and an affiliate of New York Life Investment Management LLC. MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds® are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC.

1717311

Charlie Reinhard

Chief Portfolio Strategist, MainStay Investments

As head of portfolio strategy at New York Life’s MainStay Investments, Charlie Reinhard leads investment thought leadership and portfolio construction efforts across MainStay mutual funds and IndexIQ ETFs

Full Bio

Leave a Reply

Your e-mail address will not be published.