Tax Changes Mean Muni Yields Look More Attractive

Includes: LQD, MUB, QLTA
by: Matt Tucker, CFA

The past few months have been an interesting time for municipal bonds. Thanks to the drama leading up to the fiscal cliff, these tax-advantaged securities were first in hot demand as a potential safe harbor against tax increases, then experienced a sell-off in December amid speculation that their tax-exempt status could be removed for high-income households. Now that much of the tax uncertainty stirred up by the fiscal cliff has been resolved, munis seem to be back in investors’ good graces.

In fact, now more than ever, we may see an uptick in muni bond popularity, since tax rates have increased for all income earners in 2013. Munis tend to pay a lower yield than their corporate bond counterparts, but the income they kick off is exempt from federal income taxes. So how do investors know if a muni or corporate bond offers a higher yield after taxes? By using the following formula to decipher a muni’s tax equivalent yield (TEY):

Let’s walk through an example. For 2013, the highest federal tax bracket has increased from 35% to 39.6%. Additionally, the 3.8% Affordable Care Act (“ACA”) Net Investment Income Tax* is now in effect, so the new marginal federal rate for the highest bracket is 43.4%. For an investor in the highest tax bracket, this means that the TEY for the iShares National Muni Bond ETF (NYSEARCA:MUB) – which currently has a yield to maturity of 1.88% – is 3.32%.

Now compare this yield with that of taxable bonds, such as the iShares Investment Grade Corporate Bond ETF (NYSEARCA:LQD), which has a current yield to maturity of 3.04%. All else equal, for an investor in the highest tax bracket, the TEY of MUB is higher than the yield currently being paid by LQD. In addition, MUB’s duration is 6.09 while LQD’s is 7.75, so MUB is providing a higher TEY with lower duration risk.

But municipal bonds have historically had fewer defaults than corporate bonds, so a more apples-to-apples comparison for MUB might be higher quality corporates. The iShares Aaa-A Rated Corporate Bond ETF (NYSEARCA:QLTA) holds bonds rated Aaa-A. The fund has a yield to maturity of 2.30% and a duration of 6.46. Notice that MUB is yielding over 100 basis points more than QLTA, but both are similar in duration and credit quality.

Now, this isn’t to say that MUB is the better option for every investor. It’s important to consult an expert when making any investment decisions based on taxes. It’s also key to understand the role that the bond is playing in your portfolio – if income isn’t your first priority, for example, then yield may not be the most important data point in your decision. But regardless of your strategy, when it comes to evaluating a municipal bond’s value, remember to use tax equivalent yield to put it on equal footing with taxable securities.

*The Patient Protection and Affordable Care Act was enacted in 2010 and imposed a 3.8 percent net investment income tax (“NIIT”) on higher income taxpayers for tax years beginning in 2013. For individuals, the tax is assessed on the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (AGI) over a threshold amount, generally $250,000 for married taxpayers filing joint returns and $200,000 for single taxpayers. Net investment income includes, but is not limited to interest, dividends, royalties, rental income, and net gain from the disposition of property. Such investment income is reduced by properly allocable deductions to arrive at net investment income. Tax exempt interest (e.g., Interest from municipal bonds) is not subject to the NIIT. The NIIT does not apply to nonresidents of the U.S. and will not affect income tax returns for the 2012 taxable year that will be filed in 2013. The information provided is neither tax nor legal advice. Tax laws and regulations governing the NIIT are complex. Investors should speak to their tax professional for specific information regarding their tax situation.

Disclaimer: 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.