If you have noticed the recent improvement of market values in your tax-free bond portfolio, you can at least partly thank Washington. Current federal initiatives have led to stronger prices, while the prospects of other new federal programs are creating exceptional buying opportunities now.
BABs’ strong showing
Consider the case of Build America Bonds (BABs). Part of the Obama Administration’s economic stimulus package, the program allows state and local governments to issue taxable bonds and receive a 35% rebate from the federal government. This government subsidy enables issuers to borrow at a lower net rate than would be available to them in the tax-free market.
The bonds, which have been used to finance everything from schools to infrastructure projects, have been a hit with traditional taxable bond investors. In fact, BABs have been so well received that John J. Cross, the Treasury’s tax legislative counsel, has suggested that the government consider expanding the program.
According to the Municipal Securities Rulemaking Board (MSRB), in the first two months of their existence, the primary and secondary market trading of BABs totaled $23 billion on more than 30,000 trades.
From April 15 through June 11, according to the MSRB, there were 79 issues from 25 states. This issuance is causing a noticeable decline in the supply of tax-free bonds and strengthening prices. Although issuance of total municipal debt declined by 18% in June from a year earlier, taxable municipal debt grew to 20% of the total issuance.
This reduced supply of tax-free bonds has caused prices of these securities to rise, and yields to decline, in all maturities.
Surtax would spur interest in munis
Another factor bolstering the appeal of muni bonds is the possible imposition of a surtax to fund a new national health-care plan. According to the nonpartisan Tax Foundation, the latest proposal from House Democrats would impose a surtax of 1% on married couples with adjusted gross incomes between $350,000 and $500,000 (singles between $280,000 and $400,000), 1.5% on couples with incomes between $500,000 and $1 million (singles earning between $400,000 and $800,000) and 5.4% on couples earning more than $1 million (singles beyond $800,000).
“More than three-quarters of the states would face combined top income tax rates exceeding 50% under this latest health care funding proposal,” Tax Foundation President Scott Hodge said. “That means government would be taking more than half of every additional dollar from high-income taxpayers. The lowest top tax rate would be about 47% – and that’s in the nine states that don’t tax wages.”
Bond buyers clearly understand the tax implications of these government initiatives and are taking advantage of current favorable pricing. We have seen renewed interest in munis from current bondholders and an influx of new investors, which mirrors national figures showing individuals adding more than $17 billion to their bond holdings since the beginning of the year.
This trend has dramatically increased the cost of waiting, which we cautioned investors about in our April commentary (“Why Waiting Won’t work”). At that time, high quality tax-free bonds were available yielding 6.00%. Even after the recent rally, highly rated long-term tax-free munis can still be purchased to yield between 5.00 and 5.50%, while 30-year taxable Treasury bonds yield approximately 4.50%.
With continued government involvement, we expect the current trend to continue, and suggest investors take advantage of the handsome returns available on tax-free bonds today.