Courting Municipal Bonds – Your Portfolio Just Got More Attractive - Part 1

Courting Municipal Bonds – Your Portfolio Just Got More Attractive - Part 1

[caption id="attachment_437" align="alignleft" width="150"]John G. Finley, CFA John G. Finley, CFA[/caption]

Investors finally got an answer to the question that had dominated the typically quiet municipal (muni) finance community: whether or not the federal government would tax the interest on municipal bonds in 2013 and future years. Despite speculation to the contrary, munis dodged the tax arrow – for now. Time will tell if the fed’s affection for the muni market will last through spring. If not necessarily dangerous, the current liaison between bonds and taxation is tenuous at best.

Earlier in 2012, rumors about a large spate of municipal bond defaults and endless rumblings about the looming fiscal cliff caused some deep consternation and ambiguity in the muni bond market.

“Some investors began to cut and run and mutual fund holders took their gains at the end of 2012,”

explained Tom Futrell, CFA, Senior Portfolio Manager for Municipal Bonds at Performance Trust Investment Advisors.

Investors booked their gains so they didn’t have to pay the increased tax rate.

Loyalty Returns

Fealty pays off and investors, who can recognize the attractive opportunities in the municipal bond market, a market valued at $3.7 trillion, may reap the benefits in spades. “In fact,” he said, “investors even received some good news with the fiscal cliff deal passed by Vice President Joe Biden and Senate Republican Leader Mitch McConnell made on January 1st.”

Tis The Season For Munis According to Futrell, municipal issuers tend to take January (and part of February) off so the issue load is usually light this time of year. But, when President Obama signed the ATRA into law on January 2, the bond market sat up and took notice. The American Taxpayer Relief Act of 2012, H.R. 8 (ATRA), preserves many of the key tax provisions passed during the George W. Bush presidency, which were scheduled to lapse at the end of 2012.

With changes that largely target high-income taxpayers, ATRA permanently retains some favorable tax provisions passed during the Bush era, most importantly the individual income tax rate structure as well as the tax-exempt status enjoyed by municipal bonds and some funds. The ATRA has provided clarity to the murkiness surrounding the market the past year, resulting in an unseasonably warm winter for mutual fund flows thus far in 2013. A propitious season for munis indeed.

The ATRA’s provisions for increased taxes on higher income brackets make municipal bonds more attractive and investors are not immune to their charms. The new rules increase the income tax rate from 35 percent to 39.6 percent on income above $400,000 for individuals and $450,000 for married couples (For more details on the tax implications in the ATRA, read Rob O’Dell’s A Breakdown of the American Taxpayer Relief Act of 2012). “Granted, regardless of income level, investment savvy, or personal finance philosophy, I’d venture to say that virtually no one actually likes paying taxes. But for the muni finance world, an increased tax on wealthy investors actually makes munis more valuable,” adds Futrell.

The 3.8 percent Medicare tax, imposed on earnings that cause adjusted gross income to exceed $200,000 for individuals and $250,000 for joint taxpayers may also drive investors to seek out more tax-advantaged investments, like municipal bonds and taxexempt funds.

In Part 2, we'll finishing looking at what's new with municipal bonds.

If you would like to talk about whether municipal bonds are right for you, give us a call or shoot us an email:

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