I am reluctant to again bring politics into my comments, but, it is the reality we face as investors today. The election sent shockwaves through the markets and tax-exempt municipals took a hard fall ending the year with only a modest positive return. This dislocation can be partially attributed to uncertainty surrounding what the market perceives as possible cuts to individual and corporate tax rates. The current Alaska budget woes add another twist which I’ll address as well.
What does this mean for tax-exempt investments?
If tax rates were to fall, the attractiveness of tax-exempt investments fades vis-a-vie taxable investments such as traditional corporate and federal government bonds. We utilize what we refer to as a ‘tax-hype’ to determine relative value at any given point in time. That means taking a client’s current and anticipated tax position and calculating comparative returns for taxable and tax-exempt investments. For example, as of this writing, a current 10-year AA municipal bond is yielding 2.53% compared to 3.22% for a similarly rated 10-year corporate bond. However, for an individual in the highest marginal tax bracket of 43.3% (inclusive of the 3.8% Obamacare tax) investing in a 10-year corporate bond would need to return 4.47% to net the client the same amount after taxes when compared to a tax-exempt security. It is even more compelling to a corporation that is subject to Alaska’s 9.4% corporate income tax. If Alaska adopts a personal income tax and allows for municipal interest to be excluded there would be added benefits for individuals too.
BUT, (there’s always a ‘but’) we don’t know when taxes will change or what the rate will be. However, we can make calculations based upon what president-elect Trump and congress are suggesting. Under what is currently being proposed, the highest marginal tax bracket would drop from 43.3% to 33.0%. This analysis suggests the 10-year corporate would need to return 3.78% making it still attractive to the highest earners while those in the 28% marginal bracket would be indifferent. Investors in higher tax brackets would reap greater benefits from owning municipals, and investors in lower tax brackets would be better off buying corporates … ceteris paribus (all else being equal). This is something to consider and discuss further with your investment professional as we navigate the dynamic political environment ahead.
SVP, Fixed Income
Yield curve comparison between AA rated corporate bonds (blue) and AA rated municipal bonds (green).