While there are many question marks in the battle between Congress and the Administration over avoiding the “fiscal cliff,” one thing is certain: municipal bonds remain an investor’s best friend.
In fact, they may be investors’ only friend.
Will our political leaders reach an agreement to avoid triggering more than $600 billion in automatic federal spending cuts and tax hikes before Jan. 1, a situation popularly known as the fiscal cliff? If so, what will the plan look like?
While it’s anyone’s guess which way the political winds will blow, Washington’s determination to raise revenue to help curb the deficit is fueling historic demand by investors seeking tax-free income.
Demand heats up
As Bloomberg reported, the interest rate on 20-year general obligation bonds fell to 3.15% last week, the lowest since 1967. The yield on 10-year benchmark munis fell to 1.6%, a record low for the Bloomberg Valuation index, which began in January 2009.
The “Bond King,” PIMCO’s Bill Gross, said he’s continuing to load up on munis. His $281 billion Total Return Fund already holds its most municipal debt in six years. Gross likes their relative value advantage.
Traditionally, munis yield less than Treasuries, with investors willing to accept the lower yields because their interest is tax free. Since 2001, muni yields have averaged about 93% of Treasuries.
However, yields on 10-year munis are now roughly on par with Treasuries. For investors in the top tax bracket, for example, a 1.65% muni yield has a taxable equivalent yield of 2.54%.
Gross also likes their stability compared with other fixed-income investments, which are subject to price fluctuations resulting from Europe’s debt problems.
Uncertainty persists
For the average investor, it’s practically impossible to keep up with the myriad proposals to raise tax rates and/or reform the tax code.
The Administration has floated the idea of capping the tax-exemption for interest on municipal bonds to 28%, down from 35%, but this has met with resistance as it would raise borrowing costs for smaller municipal issuers, just as state and local governments are beginning to recover from the longest recession since the Great Depression.
Most analysts say there are better alternatives than a cap, such as reducing the number of issuers eligible to sell tax-exempt debt. However, they feel an increase in the tax rate is more likely than a reduction in the tax exemption – again, a positive for muni bondholders.
Many possibilities, one truism
The possible scenarios are virtually limitless. Though there will surely be an army of prognosticators anxious to offer their take on various proposals, the practical implications are simple: the government is hungry for revenue, which makes the muni tax exemption more valuable.
The steady demand for income from retiring baby boomers will not abate anytime soon, particularly with the Federal Reserve promising a lower interest rate environment well into the future.
Securities that successful investors have used for generations – and some have derided as being as exciting as watching paint dry – are today more important than ever.