Municipal bonds gain appeal under tax law

For many people with hefty state and local tax bills, the new federal tax law gives municipal bonds a powerful new appeal.

That is because the new law caps the state and local tax deduction that can be claimed on federal returns at $10,000. For many households, that cap will outweigh any potential benefits from other changes in the law.

For such people, tax-free investment income becomes ever more valuable — and municipal bonds can fit the bill.

The interest income paid on municipal bonds is exempt from federal tax. And if you own municipal bonds issued within your state, the interest income can also be free of state (and often local) tax.

What’s more, the economic backdrop for 2018 could make municipal bonds one of the better slices of the fixed-income market. Municipal bonds are less sensitive to interest rate changes than, say, Treasury bonds, whose yields have been rising as Federal Reserve interest rate policy shifts, and with glimmers of inflation getting off the floor.

A high-grade, 10-year municipal bond issue currently has an average yield of roughly 2.5 percent. That compares with a 3.3 percent taxable yield for someone in the 24 percent federal tax bracket, and 4 percent for a taxpayer paying the top federal rate of 37 percent. The taxable equivalent yield is even higher if the income is also exempt from a state tax.

By comparison, the yield on a 10-year Treasury bond is below 3 percent, and the yield on the Vanguard Total Bond Market Index fund, which invests in taxable government and corporate bonds, was recently only 2.5 percent.

Despite the appeal of munis, though, you need to be careful: The muni market can be tricky.

For one thing, amid fiscal belt tightening since the financial crisis, the pace of new municipal bonds hitting the market has declined. The tax law revision also eliminated advance refunding issues, a type of municipal bond financing that accounts for around 15 percent of the market, intensifying supply constraints.

At the same time, individual investors own about 70 percent of the municipal bonds, and demand from them seems likely to remain strong. Morningstar Direct reported $34 billion in net inflows to municipal bond funds and exchangetraded funds in 2017 — even before investors in high-tax states had the chance to huddle with their advisers to assess the impact of the new tax law.

With hungry investors chasing a smaller pool of municipal issues, the prices of bonds are likely to be bid higher. (In the world of bonds, yields move in the opposite direction from prices, so higher bond prices mean lower yields.)

That pressure has already caused the yield difference between municipal bonds and comparable Treasurys to widen — reducing the muni advantage. For much of the last decade, the tax-free yield on a 10-year high-grade municipal bond was at least 90 percent of the taxable yield on a 10-year Treasury. That ratio is now down to the low 80s. Hugh McGuirk, head of the municipal bond team at T. Rowe Price, expects that this ratio will “be even under more pressure” as a result of these supply and demand issues.

High-yield municipal bonds carry more risk, but John Miller, co-head of fixed income at Nuveen Asset Management, expects them to have a solid 2018, mainly because he does not see a recession on the near-term horizon. With low unemployment and rising home values, the vast majority of municipalities are seeing tax revenue increase.