New Tax Laws Drive More Americans Into Muni Bonds
By Heather Gillers and Richard Rubin
Investors in high-tax states like New York and California are piling into municipal bonds this year, fueled in part by the 2017 tax overhaul that raised tax burdens for some high-income households.
The purchases are driven by taxpayers' desire to generate tax-free income, and this year's buying surge started right as taxpayers were seeing the full impact of the new law.
Mutual and exchange-traded funds containing California, New York and New Jersey munis have received a combined total of $6.5 billion in inflows this year through the end of July. The inflows marked the most of any seven-month period since at least 2014, according to Lipper. People started completing the first tax returns under the new law in late January and February.
The purchases add to the already-high demand for municipal bonds, pushing up bond prices further and diminishing the benefit taxpayers are seeking. But they also make it easier and cheaper for governments to borrow.
"High-income taxpayers oftentimes were a little bit taken aback by the fact that their tax bills either stayed pretty flat or maybe their aggregate tax bill increased. And that always raises a question of: What can I do about this?" said Suzanne Shier, chief tax strategist for wealth management at Northern Trust Corp.
The vast majority of taxpayers got federal tax cuts under the law, but 12% of those with incomes over $1 million got tax increases.
That's partly because the new law capped at $10,000 the amount of state and local tax bills Americans could deduct from their federal taxable income. This hit the wallets of some high earners in high-tax states and layered the full burden of state and local income taxes atop federal taxes.
Affluent taxpayers are generally the ones most able to reshape their investments to save on taxes. In some cases, they now face higher marginal combined income-tax rates than they did under the old law, giving them a larger tax incentive to invest in municipal bonds. Munis throw off interest that is free from federal taxes and generally from state taxes in the state where the bond was issued.
Advisers said sophisticated taxpayers moved quickly after the new law took effect, and taxpayers who bought munis in the immediate aftermath of the law generally got a bigger advantage than this year's second wave of buyers. Since the end of 2017, municipal bonds have produced returns of 2.3% nationwide and 2.5% for California bonds, according to Bloomberg Barclays.
As prices rose, driving down the income investors could earn from munis, the benefit to taxpayers seeking to cut their tax bills diminished.
"The spoils go to the early birds in this sort of thing," said Tim Steffen, director of advanced planning at Robert W. Baird & Co. in Milwaukee.
Nicholos Venditti, who manages a portfolio of $500 million in tax-exempt California bonds for New Mexico-based Thornburg Investment Management, said recently he has counseled California clients eager to invest that they may be better off in Treasurys or municipal debt from other states.
"I want all the money I can get," Mr. Venditti said. "But right now, today, there are not a lot of great options in the California market for me to invest in."
The demand for municipal debt issued in high-tax states has lowered borrowing costs for governments. In a deal priced last week, San Francisco's Bay Area Rapid Transit, or BART, system will pay a yield of 1% on a six-year bond. The benchmark rate for a muni bond with a similar maturity date and creditworthiness was 1.19%, according to Thomson Reuters.
Also pushing up municipal-bond prices over the past several months: expectations of a Federal Reserve interest-rate cut enacted last week, an appetite for fixed-income investments amid a 10-year bull market in stocks and a drop in supply that is another result of the 2017 tax overhaul. Congress ended the tax exemption for bonds refinanced before the refinancing date agreed upon in the bond agreement, driving down new issuance. Also, governments anxious about what Congress would do rushed to issue bonds in late 2017 before the bill passed, leading to a lull over the past year.
To get higher yields that are tax-free in California, some investors are pushing deeper into riskier municipal debt such as bonds issued for charter schools, nursing homes and real-estate development projects. Governments confer their tax-exempt borrowing power on those entities because they are seen to spur economic development or have some other public benefit.
"When we bring a high-yield bond issue to market, we receive a lot of demand from a broad swath of buyers," said Sara Brown, head of the California general government group at Stifel, a municipal-bond underwriter.
Advisers cautioned that investors sometimes get too enamored of the tax savings from buying in-state bonds and ignore some of the downsides. Those include lower yields than corporate debt and the danger of concentrating too much risk in one state. That is a particular concern for investors in New Jersey, where burdensome pension obligations have pushed the state credit rating to among the lowest of any state.
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