Now Municipal Bonds are Even More Attractive for California Investors
Taxpayers are losing out on $323 billion in state and local tax deductions
Before 2018, taxpayers itemizing deductions could deduct the full amount of state and local income taxes (SALT) from their federal returns. As a result of the 2017 Tax Cuts and Jobs Act (TCJA), the itemized deduction amount for SALT paid is now capped at $10,000 per return for single filers, head of household filers, and married taxpayers filing jointly.
Residents of high-tax states, such as California, are expected to feel the most pain from the new law.
How much pain? $323 billion worth nationwide, according to a report just released by the House Ways and Means Committee.1 Nearly 11 million tax filers, including almost eight million married couples filing jointly, are taking the hit. That’s almost $30,000 in lost deductions per return.
This is not just affecting the highest earners. The 2017 median California household income of approximately $70,000 faces a 9.3% state tax rate. Just a few thousand dollars of taxable investment income could push even this median California taxpayer above the $10,000 SALT limitation.
How can municipal bonds ease the pain?
Californians have always had a significant incentive to keep some of their income-producing investments in tax-advantaged securities, especially municipal bonds. The TCJA expands this by substantially limiting one of the taxpayers’ largest sources for federal income tax deductions. Consider a California municipal bond yielding 3.2%. Figure 1 shows for the median California household of $70,000, the muni bond yielding 3.2% now equates to a taxable equivalent yield of 4.7%, assuming a worst-case scenario of no SALT deductibility. For households facing higher California tax rates, the taxable equivalent yield can grow to 7% in the same scenario.
Figure 1: California Municipal Bond Taxable Equivalent Yields
Sources: Calculated based on tax rates sourced from Tax Foundation, State of California Franchise Tax Board. Past performance is not indicative of future results.
Meanwhile, the average taxable investment-grade corporate bond yields 3.9%. That’s 80 basis points (0.8%) less than the tax-equivalent yield of the municipal bond we were discussing. It’s not difficult to see that many Californians can keep substantially more of their investment income by shifting at least part of their fixed income portfolio to tax-exempt California municipal bonds.
Municipals offer higher credit quality than corporate bonds
Take another look again at Figure 1. To match the tax-equivalent yield of the California municipal bond, an investor buying fully taxable corporate bonds needs a yield significantly larger than the average investment-grade bond (the dashed line). This means taking on more credit and default risk, which investors have been doing in search of pre-crisis income levels.
Figure 2: Credit Quality — U.S. Municipal vs. Global Corporates
Sources: Moody’s as of 2017. Tax Foundation, State of California Franchise Tax Board. Past performance is not indicative of future results.
Figure 2 shows that investors can help manage this additional risk by increasing the percentage of municipals in their portfolios. Simply put, municipals offer higher credit quality than corporates. Over 75% of US municipal bonds outstanding are A+ rated or better; only a tiny portion are below investment-grade. In contrast, less than 5% of the global corporate bond market is at least double-A rated, and nearly half is below investment grade.
Municipals also offer lower defaults compared to higher-rated corporates
Municipals have significantly lower historical default rates than corporates, comparing not just equivalently rated credits but even lower-rated munis to higher-rated corporates. As Figure 3 shows, since 1986, the average default rate for Standard & Poor’s BBB-rated municipals has been 0.81%, less than the 0.84% rate for AAA-rated corporates.
Figure 3: Cumulative Historical Default Rates (%)
Source: S&P as of 2017. Past performance is not indicative of future results.
California taxpayers have two reasons to consider municipal bonds issued from their home state: to help minimize state and local taxes (thus increasing after-tax income) and as an alternative to corporate bonds, which carry additional credit and default risk. Those are pretty compelling reasons. Municipals work for many more investors than you might have thought.
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1. Treasury Inspector General for Tax Administration (TIGTA) report dated 2/22/2019
Figure 1 & Figure 2, Sources continued: Morningstar Direct & Bloomberg Barclays data as of 2/28/19, U.S. Bureau of the Census, Median Household Income in California [MEHOINUSCAA646N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MEHOINUSCAA646N, March 6, 2019.
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Municipal bond risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes, which could affect the market for and value of municipal securities. A portion of the Fund’s income may be subject to state and local taxes or the alternative minimum tax. Income from municipal bonds held by the Fund could be declared taxable because of unfavorable changes in tax law, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. High-yield municipal bonds may be subject to increased liquidity risk as compared to other high-yield debt securities. The Fund may invest in derivatives, which may increase the volatility of the Fund’s NAV. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
Because the Fund invests primarily in municipal bonds issued by or on behalf of the State of California and its political subdivisions, agencies, and instrumentalities, events in California are likely to affect the Fund’s investments and performance. These events may include fiscal or political policy changes, tax base erosion, and state constitutional limits on tax increases, budget deficits, and other financial difficulties. California may experience financial difficulties due to the economic environment. Any deterioration of California’s fiscal situation and economic situation of its municipalities could cause greater volatility and increase the risk of investing in California.
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Credit Ratings: AAA credit ratings apply to the underlying debt securities and are rated by an independent rating agency, such as Standard & Poor’s (S&P), Moody’s, and/or Fitch. S&P rates borrowers on a scale from AAA to D. AAA through BBB represent investment grade, while BB through D represent non-investment grade. Moody’s rates borrowers on a scale from Aaa through C. Aaa through Baa3 represent investment grade, while Ba1 through C represent non-investment grade. Fitch rates borrowers on a scale from AAA through D. AAA through BBB represent investment grade, while BB through D represent non-investment grade.