About the author: Edward P. Mahaffy is president and senior portfolio manager of ClientFirst Wealth Management, a registered investment adviser located in Little Rock, Ark.
What sounds better than 5% yields on short-term treasuries or CDs? How about 5% yields on high-grade, tax-free municipal bonds?
While financial news channels continuously display yields for U. S. treasury securities of various maturities, and street signs for community banks flash their CD rates, identifying the yields for tax-exempt municipal bonds can be more challenging. And while the higher yields are welcome relief for fixed-income investors, paying attention to tax treatment as well as expenses can lead to higher net returns.
Yields for individual bonds can vary by a wide margin. For instance, the yield for Bloomberg’s 30-year index was 3.75% as of Aug. 14. Compare this to the following bond, issued the week of July 31:
- Newark N.J. Parking Authority Lease Revenue bonds
- Yield-to-maturity: 4.98% to maturity
- Coupon: 5.5%
- Maturity: Feb. 20, 2051
- Callable feature: Feb. 1, 2033, at 100 to yield 4.49%
- Rating: AA by S&P
- Bond Insurer: AGM
- Cusip: 650392AL7
The taxable-equivalent yield amounts to 7.9% for investors in the 37% tax bracket, or 6.3% for those in the 21% bracket. By contrast, the yield to maturity for the 30-year U.S. treasury bond is 4.3%. Treasuries are more liquid of course, but historically, when long-term, high-grade municipals yield significantly more than U.S. treasuries of comparable maturities, the value is compelling.
All bond investors should be aware of what they own and the attendant tax treatment. This includes state income tax. For instance, treasuries are not subject to state income tax, while CDs are. This may be well-known, but municipal investors should be reminded of the more insidious aspects of the tax code. Notably, income from out-of-state municipals is subject to state income taxation and deductibility is subject to phase outs as income rises.
Phase-outs for deductions on income from out-of-state bonds can be avoided by purchasing in-state municipals, those issued in your home state. This may be easier said than done unless you are comfortable buying individual municipal bonds. As with anything else, there is no substitute for experience. Alternatives to the DIY route include purchasing a state-dedicated municipal bond fund or exchange-traded fund containing only bond issues from your home state. There may still be challenges, though. Bond funds, known for high operating expenses, offer little to no control over duration and have no stated final maturity. Some ETFs feature lower expenses with stated final maturities are available through issuers such as Invesco, but if you live in a smaller state, it may be difficult or impossible to find a state-dedicated ETF. In these instances, separately-managed accounts, or SMAs, may offer a viable alternative.
SMAs feature professional management of individual municipal bonds, the ability to customize your portfolio as to cash flow, regularly scheduled distributions, capital gains tax, de minimis tax–for bonds purchased at deep price discounts, state income tax, as well as interest rate sensitivity or duration. As always, investment management fees, advisory fees and other operating expenses should be a concern, especially in a fixed-income portfolio. It’s also important to note that, with few exceptions, advisory fees are not deductible owing to the Tax Cuts and Jobs Act of 2017, which sunsets in 2025.
To avoid state income tax, certain deduction phase outs, and to reduce unnecessary expenses, it may prove more cost-effective to maintain an SMA directly with a boutique registered investment advisor specializing in fixed-income versus accessing a fixed-income manager through a financial advisor. This approach would eliminate advisory wrap fees whereby an advisor is simply “wrapping” their fee around those of the fixed-income investment manager. Moreover, advisors may be relegated to selecting only fixed-income managers that their firm represents. Those managers may not have the strongest of relationships with the smaller in-state broker dealers, who underwrite the lion share of new issues of in-state bonds. A local or regional boutique firm may have better access to in-state bonds in both primary as well as secondary markets. This approach has the nice bonus of ensuring that your investment dollars support home-state issuers as opposed to those located elsewhere.
To determine whether you stand to benefit with an in-state bond, first assume that the state income tax rate is 7% and that the yield—whether the yield worst call or yield to maturity—of an out-of-state bond is higher than that of an in-state bond. The yield on an in-state bond would need to be at least 93% as high as the yield of a comparable out-of-state bond. This example assumes that your income is high enough to have fully phased out your deductions. To the extent that your deductions have not been phased out, the bar for realizing a benefit from the in-state bond is lower.
Whether municipal bonds are suitable for you is a question for your financial advisor or tax counsel. Given the attractive values present in the municipal bond market today, it is worth having the conversation.
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