We’re not sure who will win the presidential election, but we’re confident of one thing: Taxes will rise, regardless of who’s in the White House next year, and municipal bond investors will yearn for today’s historically high returns.
In his speech at the Democratic convention, Barack Obama made it abundantly clear that higher tax brackets for the wealthy will be a major part of his economic agenda.
Similarly, John McCain, if he is the people’s choice, will also feel compelled to raise taxes to stem the burgeoning budget deficits he will inherit from the Bush administration.
The Democratic platform calls for a return of the top tax bracket to 39.6%, where it stood prior to the Bush tax cuts in 2001. At the same time, other brackets will rise. Obama sees this as an equitable solution for lowering taxes for middle-class Americans.
Cuts both ways for muni buyers
Once again, it’s a “good news-bad news” scenario for tax-free bond investors.
Raising the top brackets will cause a de facto increase in the value of outstanding municipal bonds, which will be a welcome relief to investors who have been concerned with a decline in their market values (as we discussed in our recent commentary, “A Tale of Two Investors”)
The elation will be short-lived, however, because it probably means the end of the juicy returns currently available on tax-free bonds.
Here’s why: A municipal bond yielding 5.50% is comparable to a taxable investment yielding 8.56% for an investor in today’s top tax bracket (35%).
Increased demand for tax-free income
At the proposed rate of 39.6%, the comparable yield jumps to over 9%. This will encourage crossover buying from corporate and other taxable bond investors. This increased demand will lead to higher prices and lower yields.
Traditionally, 30-year high-grade municipal bonds have yielded between 85% to 93% of Treasury securities of comparable maturity. Today, due to a number of factors attendant to the credit crisis, long-term bonds yield up to 100 basis points more than their taxable brethren.
In our opinion, as the new administration is ushered in, today’s robust tax-free bond yields will be looked back on with nostalgia.