At What Tax Rate Are Munis Attractive?

Daniel Morillo for iSharesblog.com  writes: With all the fiscal negotiation drama in Washington, interest in municipal securities has been particularly high in the last few months. We’ve talked a lot about munis on the blog including an ongoing call that they are attractive compared with Treasury securities, particularly for taxable investors looking for income.   Last week, Matt Tucker helped explain how investors can determine if a muni or a corporate bond offers a higher yield after taxes.

But we continue to field inquiries from investors who want to go beyond comparing muni yields with Treasury yields or benchmark corporate yields. They contend that comparison misses the possibility that muni yields appear comparatively high because they may reflect a justifiable difference in their credit quality and default potential. In addition, the on-again off-again talk that the muni tax exemption itself may be at risk as part of fiscal negotiations in Washington adds to the concern that a munis comparison with Treasuries may not be an apples-to-apples comparison.

To tackle the credit quality concern I want to run through a comparison of muni yields against corporate debt yields. In particular, I’ve taken the yields of the standard 20 Bond Buyer General Obligation Index (which consists of 20-year AA-rated munis) and the yields of the Moody’s AA-rated corporate index (which are long-term and similar maturity to the Bond Buyer index)[1]. This comparison is likely conservative because historical evidence suggests that munis generally have lower default rates than corporates of similar ratings[2]. Indeed, we’ve seen that even after the financial crisis munis have shown much lower default rates than many financial commentators predicted.

To make the comparison I have focused not on the yield difference between the two types of securities, but I have instead computed the tax rate at which the two yields would be equivalent for a taxable investor. For example, if an investor faces a tax rate of 25% then a 3% yield in a tax-exempt muni security is equivalent to investing in a corporate that yields 4% — because that yield will be taxed at 25%, resulting in an after-tax yield of 3%. In this example the “breakeven tax rate” for the 3% tax-exempt muni compared to the 4%-yield corporate is a 25% tax rate.

The chart below shows this breakeven tax rate since the early 1990s. The chart also shows the actual effective tax rate for households in the top quartile of income as reported by the Tax Policy Center until 2009 (the most recent year available).

Two things are immediately obvious from the chart. First, the breakeven tax rate has, at least on average, been reasonably close to the actual effective tax rate experienced by upper-income households (those most likely to buy and hold muni securities). Second, and most important, the current breakeven tax rate, while higher than during the depths of the crisis, is well below its historical mean and below the actual level of effective tax rates over the last 15 years.

In addition to the historical comparison, current breakeven tax rates are likely to be particularly low compared to actual tax rates going forward since the recent fiscal cliff “fix” has increased marginal rates for upper income households. In addition, the 3.8% Affordable Care Act (ACA) Net Investment Income Tax is now in effect for investors holding income-generating securities in their portfolios.

So, why are we seeing this big gap between breakeven tax rates and effective tax rates? As Matt has noted on this blog, part of the explanation is that liquidity and supply issues in the muni market last year coupled with concerns that the muni tax exemption may be at risk has driven some investors to look elsewhere for yield. This has opened up a potential valuation gap between munis and other taxable fixed income instruments.

What is the bottom line for investors? This comparison chart should help demonstrate that muni yields are attractive for investors facing a tax rate this year that is similar to or higher than the one they experienced in the last few years. This is the case even when compared to corporate securities of similar maturities and credit rating. Indeed, given the higher tax rates of 2013 one would have to believe that the muni tax exemption would have to be reduced quite significantly — far beyond what has been on the table in the various fiscal negotiations — to change the basic conclusion that muni yields appear attractive not just compared to Treasuries but also across a broader range of fixed income instruments.

Daniel Morillo, PhD, is the iShares Head of Investment Research and a regular contributor to the iShares Blog.  You can find more of his posts here.

Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax. Federal or state changes in income or alternative minimum tax rates or in the tax treatment of municipal bonds may make them less attractive as investments and cause them to lose value. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.

BlackRock does not provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.

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[1] Data is from Bloomberg. Data is obtained as an index of yields, in percent, at the monthly level (the Bond Buyer Index is weekly, so the last week of every month in that case) and averaged across 6-month rolling periods.

[2] See “U.S. Municipal Bond Defaults and Recoveries,1970-2011” from Moody’s investors service.

Social CRM Batchbook To Introduce New Integration with Xero During Xerocon, Global Conference For Online Accounting Software XERO

Raymond Bonachea, vice president of marketing atsocial CRM Batchbook, during the global accounting conference Xerocon, Feb. 21-22, will formally introduce the cloud-based software’s new integration with online accounting software Xero. Small businesses and entrepreneurs who use Batchbook and Xero together efficiently organize customer data, open invoices and To-Dos in a single place, offering a streamlined view of personal and financial exchanges with their contacts. This provides them with true clarity into the personal nuances that live in their contact database – insight that helps businesses increase revenue.

With a presentation and live demonstration on the conference’s Add-on and API Day, Bonachea will outline how to: 

●    Import Xero contacts into Batchbook
●    View segmented lists of Xero contacts
●    See which contacts have open invoices and assign invoice related To-Dos

Hosted by Xero, the event promises a glimpse of company’s future, its global vision, a sneak peek at upcoming features, new revenue streams for savvy accountants and more.

How to ease the growing tax bite: 4 considerations for investing in the new tax landscape.

Mark Jewell of the AP for My San Antonio writes:  This year's tax-filing deadline is a couple months away, and many investors are beginning to review whether they made any rash moves with their portfolios to trigger potentially unnecessary tax bills. It's a good instinct to follow because it can become a teachable moment on how to become a tax-savvy investor. But it's perhaps more important now to be mindful of new tax law changes approved in the deal that lawmakers struck in January to avoid the “fiscal cliff.”

Those changes could have a big effect on taxes filed in 2014 and beyond, especially for those in the top income bracket. They'll pay higher rates — and will want to invest with a heightened sense of tax implications starting this year. The rate increases are intended to help the U.S. get its fiscal house in order, but the medicine isn't entirely bitter. Historically low rates remain intact for investors in middle-income brackets, and the worst-case scenario rate hikes that were on the table during congressional negotiations failed to become law. Another plus: The high uncertainty over taxes in recent years is largely gone. President Barack Obama and congressional leaders continue to discuss raising revenue by capping or limiting some tax exemptions. But the rate levels in the Jan. 1 agreement to avert the fiscal cliff are expected to remain in place for the foreseeable future. There's no sunset date on the rates, unlike the Bush-era tax cuts approved in 2003. “The most important thing is to have a plan, and now you can plan,” says Duncan W. Richardson, chief equity investment officer with Eaton Vance, an investment manager whose specialties include tax-efficient investing. Tax-savvy investors keep in mind the type of account in which they hold their investments. Only withdrawals are taxed from IRAs and 401(k)s, so these tax-advantaged accounts are good places to keep investments that are likely to generate a tax bill. Taxable accounts are the place to hold municipal bonds and mutual funds that invest in munis because the income they generate is exempt from federal taxes. Here are four other considerations for investing in the new tax landscape:

1. Taxes higher, still modest historically: In the year ahead, investors should focus on their tax rates for capital gains and dividends. In the middle-income tax brackets — those with adjusted gross income of $72,501 to $223,050 for married couples filing jointly and $36,251 to $183,250 for single filers — the rate remains 15 percent on long-term capital gains. Those are the profits from selling such investments as stocks or funds held for at least a year. The 15 percent on long-term gains is the same rate that applies to income from stock dividends. But the rate for capital gains and dividends has climbed to 18.8 percent for joint filers with more than $250,000 in income and $200,000 for single filers. That factors in a new 3.8 percent investment income surtax to help pay for President Obama's health care overhaul. The biggest hit will be felt by top-bracket investors — those with adjusted gross income of more than $450,000 for couples and $400,000 for individuals. They now pay 23.8 percent on long-term gains and dividends, including the health care tax. They will pay nearly 9 cents more in taxes than they did last year on each dollar of dividend income flowing into a taxable account.

Despite that increase, these rates are modest historically. In the 1970s, the top rate on dividend income was 70 percent, for example.

2. Short-term gains, big tax bite: The distinction between a long-term capital gain and a short-term gain remains important for investors in the top brackets because tax rates continue to be far higher for the latter. Short-term gains are triggered by profits earned from a taxable investment held less than a year. They're taxed as ordinary income, such as wages, and high earners now face higher income tax rates. Those in the top bracket now pay a steep 43.4 percent including the health care tax, up from 35 percent. That's nearly 20 cents on the dollar greater than what they pay on long-term gains.

3. Muni bond advantage grows: The rate also rises to 43.4 percent for income that top earners receive from taxable bonds, such as corporate bonds. As a result, those investors can realize a greater tax advantage than they could previously from investing in municipal bonds and muni funds, rather than in taxable bonds.  Investors don't have to pay federal taxes on income from munis, which invest in local and state government bonds. Munis are also free of state taxes if they limit investments to the state where you live. So consider whether munis' tax advantages will offset the higher pretax returns you'd normally expect from investing in a taxable bond fund. Look at tax-equivalent yield. It tells how big of a return you'd need from a taxable investment to equal the return of a tax-free bond.

4. Backlog of taxable gains building up: Stocks have more than doubled since the market hit bottom in early 2009. That huge gain means there's a growing likelihood that investors will be hit with tax bills from capital gains. When fund managers sell investments that appreciated in value, they pass on the taxable gains to investors each year. Managers have been able to limit their investors' tax exposure in recent years by using losses incurred during the stock market meltdown of 2008 to offset gains. But that's no longer so easy, now that stocks have made such a sustained climb. Tax exposure is typically greater at funds that trade holdings frequently. It's an especially important consideration for wealthy investors, now that they're paying higher rates. One option is to choose funds with moderate to low portfolio turnover. A fund with a turnover ratio higher than 50 percent — meaning more than half the holdings changed hands in a year — could be one to avoid. If you're investing in an actively managed fund, consider those using strategies to limit capital gains — they often call themselves “tax-managed” funds.

It's not easy to sort out all the options on your own, so it might be worthwhile to seek professional help from a financial adviser.