If you think municipal bonds are having a great year, wait until after tax season.
That’s the opinion from bullish market participants who say municipal debt will see continued interest from wealthy households drawn to tax-free income, once many take a look at their tax bills. Analysts say the cutback in local tax deductions in the Tax Cuts and Job Act, passed in Dec. 2017, will stoke demand for municipal bonds this year among those living in high-tax states such as New York.
This year will be the first time taxpayers see how President Donald Trump’s tax legislation personally affects them.
“Retail demand may strengthen further as investors are likely to place a higher value on the tax advantages of municipal bonds after realizing the disappointing impact of reform during tax season,” wrote Peter Hayes, head of BlackRock’s municipal bonds group, which manages nearly $130 billion in assets.
Moneyed households like to invest in municipal bonds because their interest payments are exempt from federal income taxes. These benefits ratchet up for those sitting in higher tax brackets.
Analysts at Raymond James said interest in municipal bonds has perked up among those living in states charging high taxes after Trump’s tax legislation in 2017 capped state and local tax deductions (SALT) at $10,000. In the 2015 filing season, taxpayers in New Jersey, California and New York claimed an average SALT deduction over $17,000, according to analysis from the Government Finance Officers Association.
In a February audit, the Treasury Inspector General for Tax Administration estimated around 11 million taxpayers would be hurt by the cut to state and local tax deductions.
Wealthy households won’t grapple with these changes until later in the tax season because their complicated finances mean they receive extra documentation needed to file taxes much later than others, leaving them an incomplete picture of the tax cut’s impact.
“Most high-end taxpayers don’t really see their tax bill until right before April 15, so many won’t react to [the tax legislation] after April 15,” said Tony Roth, chief investment officer for Wilmington Trust Investment Advisors, a wealth management firm dealing with high net worth individuals.
Roth said moneyed individuals often hold investments in master limited partnerships and other forms of limited partnerships, which tend to send tax forms on the income from such partnerships closer to April 15.
And municipal bond analysts say though the Tax Cuts and Jobs Act of 2017 cut the tax bill for high earners, which should have blunted demand for tax-free bonds, the savings were more diminished than advertised.
“The strong interest and inflows we are seeing from individual investors so far this year is less about sudden realization of the tax law’s impact, and more about the gradual realization that despite a nearly 3% reduction in the top rate, the top bracket remains elevated at 37%,” wrote Alan Schankel, a municipal strategist at Janney Montgomery Scott, in e-mailed comments.
The discovery that changes to the U.S. tax code preserves the attractions of tax-free income should pave the way for further inflows into the municipal bond market even after tax season, in an already solid year for demand.
Investors have plowed $15 billion of cash into municipal bond funds in the first eight weeks of the year, helping such funds enjoy their best year-to-date inflows since 2006, data from the Investment Company Institute show.
Still, municipal bonds aren’t cheap. By one measure, the so-called muni-to-Treasury-yield ratio — a tool most commonly used to value the performance of the municipal bond market — municipal debt appears historically overvalued.
The 10-year AAA muni-to-Treasury-yield ratio stood at 77% in Feb. 28. Any number below the historical average of 80% is considered a sign municipal bonds are expensive compared with Treasurys.
But valuations won’t diminish appetite for tax-free yield when investors don’t expect much further gains in the stock market in 2019 after their blistering start to the year, said Roth.
The S&P 500
and the Dow Jones Industrial Average
are up more than 10% year-to-date.
“Investors are going to increasingly wary of equities, and muni bonds are the obvious alternatives,” he said.
In addition, global growth concerns have strengthened demand for highly-rated municipal debt. That has been aided by diminishing talk of municipal defaults, in part because of low interest rates and an extended economic expansion have helped heal once-strained local government finances.
“Bad memories such as Detroit and Stockton are fading in the rear view mirror, so the municipal market is again more palatable to risk-adverse investors,” said Schankel.