Municipal Debt and Higher Taxes

Today our focus is going to be on the municipal market and its value in a higher tax environment. First, let’s take a look at a few trends in this sector. The charts below illustrate the direction of municipal rates over the past year, three months, few days and how dramatically they have moved during this time(s).

AAA Rates Now Versus One Year Ago (3/19/2020 vs 3/19/2021)

                                                                         Bloomberg 03/24/2021

AAA Rates Now Versus the End of December (12/30/2020 vs 03/19/2021)

                                                                        Bloomberg 03/24/2021
 

AAA Rates Now Versus Powell’s Recent Comments (3/15/2021 vs 3/19/2021)

                                                                         Bloomberg 03/24/2021
                                   

What event could keep an increase in municipal rates from following that of taxable rates?

Logic would say, the recently discussed tax cut roll backs and or tax bracket increases would be positive in the sense of how municipals could benefit your portfolio.  An increase in taxes will  have a direct impact on the taxable equivalent yield (TEY) of municipal bonds.

The municipal yields used to compare treasuries and other taxable fixed income are “taxable equivalent yields”. As you know, taxable equivalent yields are what investors use to compare the returns between a tax-free investment and a taxable alternative.

For example, a 1.50% double exempt muni in a 35% marginal federal tax rate equates to a TEY of 2.31%. The math looks like this: .0150 divided by (1-.35) to give you a TEY of 2.31%. In a 50% marginal bracket, they TEY jumps to 3.00%.  Investors are now left wondering the direction of any change to existing tax policy and how this will impact returns.

A 1.50% in a 21% bracket corporate bracket is a 1.90% TEY, no penalties considered.  If the rate for corporations goes to 28%, which is the scuttlebutt now, then (in this example) the TEY increases to 2.08%.  This very clearly illustrates how beneficial municipal holdings could be to a portfolio if taxes are on the way up.

It would seem logical that we are only at the beginning of the conversation on higher taxes given the amount of new stimulus introduced over the past year.  An Increase in income taxes will  make municipal investments look attractive to own, all things considered.

Stay tuned…