Municipal bonds may be more attractive given today’s tax code

Looking back on the last few years, one can certainly argue that today’s municipal bond market is no longer your grandfathers’ municipal bond market. Like many fixed income asset classes, municipal bonds recently have become an option for institutional investors around the world as managers seek sources to generate alpha. The global spotlight on this newfound market has led to a dramatic increase in the frequency of municipal bonds in the financial headlines.

This has certainly been the case during the past two years, with overwhelmingly negative headlines concerning (1) potential tax reform issues and their effects on municipal bonds broadly, (2) substantial pain in Puerto Rico’s economy, and (3) Detroit’s bankruptcy filing. While the media has been fixated on such negative developments, we believe there's a more-important truth: While the municipal market remains a diverse and healthy one, recent tax initiatives have only bolstered the potential attractiveness of municipal bonds for some investors.

The impending arrival of higher taxes

Exiting 2010, investors were staring at higher taxes (beginning in 2013), as a result of the 3.8% unearned income Medicare tax passed under the Healthcare and Reconciliation Act of 2010. In addition, investors were faced with the expiration of the Bush-era tax cuts when continued economic weakness, post financial crisis, forced legislators to extend those tax cuts for an additional two years.

The sunset of the two-year extension fell in the middle of the U.S. fiscal cliff negotiations at the end of 2012. As a result of the negotiations, the American Taxpayer Relief Act of 2012 was passed, resulting in significant changes to the tax code, and subsequently altering the investing landscape.

Among the most notable changes were the additions of new tax brackets, as well as adjustments to the upper income brackets. Furthermore, the new tax code brought along:

  • a steeper capital gains tax
  • a modification in the alternative minimum tax
  • an increase in the estate tax
  • the taxation of dividends at ordinary income for the top marginal tax rate
  • the phasing out of exemptions (and tax deductions/credits) at certain income levels

The above provisions went into effect in January 2013, in addition to the 3.8% Medicare tax that was passed in 2010. On top of the changes made at the federal level, several states also instituted tax initiatives to bolster their own finances.

For some investors, these tax changes have made municipal bonds an even more attractive investment alternative, further enhancing their potential role as a key core investment for fixed income portfolios.

Changing tax regimes: 2012 versus 2014

At the state level

Comparing a bond’s taxable equivalent yield (TEY)1 in 2012 and 2014 may best illustrate the effects that the tax changes have had on investor returns. For example, a 30-year general obligation issued by the state of California would provide an additional 89 basis points (or more than 14%) in taxable equivalent yield for non-resident investors in the highest tax bracket in 2014 versus the yield before the recent tax changes were implemented in 20122.

View chart
Taxable equivalent yield in 2012 and 2014

Taxable equivalent yield in 2012 and 2014

Data: IRS (taxation rates); Delaware Investments (tax-equivalent yield calculations).

Chart shown is for comparison purpose only

For a resident of California, the effect is magnified, due to the substantial tax initiatives taken by the state.

In this case, the investor earns approximately 134 basis points (or 20.06%) more in taxable equivalent yield, simply based on the effects of higher taxes. By comparison, a solid generic corporate bond with a similar A-rating would currently yield 5.23%.

At the federal level

The 2012/2014 difference remains similar when the effects of tax changes at the federal level are isolated. (This is important because state-level effects are less consistent, as they vary from state to state). Though the 28% bracket was left unchanged from the rates in 2012, the increase in taxes in 2014 has resulted in higher TEY for all tax brackets 33% or higher. For example, the corresponding pick-up at the highest tax bracket in 2014 versus 2012 (assuming the bond is generating a tax-exempt yield of 6%) is 137 basis points (or approximately 15%). This pick-up is magnified for investors in states that have initiated their own tax changes, as illustrated in the aforementioned California general obligation bond example.

Federal marginal tax rates and tax equivalent yields*

2012 — Federal tax bracket (%)
  28 33 35
Benchmark tax
exempt yields
(%)
Tax equivalent yields
(%)
2.0 2.78 2.99 3.08
3.0 4.17 4.48 4.62
4.0 5.56 5.97 6.15
5.0 6.94 4.46 7.69
6.0 8.33 8.96 9.23
2014 — Federal tax bracket with Medicare tax (%)
  28 36.8 38.8 43.4
Benchmark tax
exempt yields
(%)
Tax equivalent yields
(%)
2.0 2.78 3.16 3.27 3.53
3.0 4.17 4.75 4.90 5.30
4.0 5.56 6.33 6.54 7.07
5.0 6.94 7.91 8.17 8.83
6.0 8.33 9.49 9.80 10.60

Data: IRS (taxation rates); Delaware Investments (tax-equivalent yield calculations).

*Assumes that the 3.8% Medicare tax is applied to investment income for Federal marginal tax brackets of 33% and above. Some investors may not be subject to all or any of the Medicare tax.

A steady pace despite headwinds

The municipal bond market has dealt with many obstacles and a barrage of negative headlines since the financial crisis. But in many ways the market has evolved and gained popularity with a broader investor base worldwide, all while navigating periods of intense volatility. The one consistent positive has been the inherent value of municipal bonds. Difficult economic times have resulted in a need for governments to increase revenues by raising taxes.

Consequently, we believe the implementation of higher taxes — at the federal, state, and local levels — has only enhanced the attractiveness of municipal bonds. This is because on a tax equivalent basis, the value of the tax exemption rises as rates go higher.


1Taxable equivalent yield is defined as the yield a taxable bond must generate in order to equal the yield generated by a tax-free investment.

2Note that this is for a bond with a 5.00% coupon that matures in 2042.

The views expressed represent the Manager's assessment of the market environment as of May 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. The Funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Funds may be prepaid prior to maturity, potentially forcing the Funds to reinvest that money at a lower interest rate.

High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds.

Funds that invest primarily in one state may be more susceptible to the economic, regulatory, and other factors of that state than funds that invest more broadly.

Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable.

The term "alpha" refers to a given portfolio's return that exceeds returns generated by simple market movements. In other words, it is the component of total return that is inherent to the portfolio — not the market.

This material is not intended to be construed as tax advice. Consult your tax advisor to discuss your personal tax circumstances.

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