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Are muni investors pricing in tax increases? Investors continue to pour cash into the municipal bond market. Last month we wrote that most of that cash was put to work in short to intermediate bond funds. Now it appears that long-term funds are receiving significant inflows. For the most part, muni yields as a percentage of Treasuries are below historical averages. Normally, one would say that munis are therefore expensive relative to taxables. However, it may be that munis are actually “cheap” if one assumes that tax rates are rising. We know already that the Bush Administration tax cuts are set to expire at the end of 2010. The top marginal Federal tax rate will rise from 35.0% to 39.6%. Below are two after-tax yield curves – one at the current maximum rate of 35.0% and the other at the old maximum tax rate of 39.6%.
At the current bracket of 35.0%, AA-rated munis yields for 1-5 maturities are largely on top of those of agency paper on an after-tax basis. However, at the old maximum rate of 39.6%, munis have a more distinct advantage. In addition, remember that the Bush tax cuts also included lower capital gains and dividend taxes. When those provisions expire, munis will remain as the major source of tax-advantaged income, further enhancing their allure for income-oriented investors. The question is why are investors aggressively buying shorter munis? Part of the answer may be that investors may be simply shifting from zero-yielding money market funds into shorter maturities simply to garner additional yield. However, they are doing so without carefully examining taxable bonds. Another possibility is that investors are expecting Federal tax rates higher than the pre-Bush rate of 39.6%. In orderto lower the deficit and pay for expanded social programs, the Obama administration may push for a new “millionaires’” tax bracket and perhaps higher tax rates across the board. Attached are estimates prepared by the Congressional Budget Office of how much additional revenue may be garnered with higher income tax rates. “Budget Options Volume II” http://www.cbo.gov/ftpdocs/102xx/doc10294/08-06-BudgetOptions.pdf. A 44.6% “millionaire’s tax” is estimated to generate $86.3 billion in marginal revenues from 2010 to 2014. This is just one-third the $267.4 billion that a 1% across the board increase can generate. It may very well be that both a new bracket and generally higher rates are incorporated to bring about meaningful revenue generation. It is likely these newer rates would be introduced after the mid-term elections in 2010. Below is an after-tax yield curve at the hypothetical “millionaire’s rate” of 44.6%. Even at the millionaire’s rate, muni yields are just marginally attractive for shorter maturities.
Though higher taxes may be in our future, the increase in tax rates alone is not enough to justify the low relative yields on short-term municipal bonds. While the greatest yield advantage of munis is on the longer end of the yield curve. Caution must be exercised when venturing into long duration bonds. In the reach for yield, investors must be mindful of the increased risks, particularly of rising interest rates. Below is a table of one-year total returns for various tax-exempt maturities should rates rise by 50 basis points across the board. While we do not anticipate a sustained rise in interest rates for at least another six months, we must be prepared to shift into lower duration assets in the not too distant future.
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