Why Obama Could be Better than Romney for Municipal Bonds

 

(April 2012) This article is not about what the best tax policy is.  I leave that debate to the Paul Krugman and Grover Norquist types, or more to the point, President Obama and Governor Romney.

However, I am interested in exploring the potential consequences to bond investors of changes in tax policy. If President Obama is re-elected and is partially successful in getting his tax agenda passed, I believe that both municipal bonds and corporate bonds could rise in price. Conversely, I see a Romney election as slightly positive for corporate bonds and slightly negative for municipal bonds.

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Chief Market Strategist at LPL Financial Jeff Kleintop’s commentary, “A Taxing Issue For Investors”, served as the launching point for this article. Let’s start by summarizing some of his key points (italics are direct quotes):

Tax Policy Has No Impact On Treasury Interest Rates and Prices

Historically, changes in income tax rates that apply to interest income appear to have had little, if any, direct impact on government bond yields. Yields rose  with inflation in the 1970s and fell as inflation fears receded over the vast majority of the last 30 years, regardless of tax code changes or their impact  on the deficit. 

 

Municipal Bond Prices May Rise As They Protect Against Rising Income Tax Rates

The potential for higher income tax rates applied to interest income is likely to make municipal bonds even more attractive to investors as credit fears fade.

LPL Believes That Dividend And Capital Gains Taxes Will Increase To 20-30%

Based on our analysis of the tax debate in Washington, we place the highest probability on the dividend and capital gains tax rates both rising to 20–30%. However, a reversion to the much higher rates that preceded the Bush tax cuts or a one-year extension of all current tax rates of 15% are also possible outcomes.

In addition, LPL assembled the table below that compares 2012 tax rates, what currently is in place for 2013, and what things would look like under both Obama and Romney supported proposals.

Taxes Are Scheduled To Rise Dramatically Next Year On Dividends and Interest Income

Assuming there are no changes to the tax code, federal taxes are going to rise dramatically next year, by about 25% on interest income, and by close to 200% on dividend income. If this takes place, the biggest winner will be federally tax-free municipal bonds, as income focused investors reallocate money from high-dividend paying stocks and corporate bonds into municipals. The effect on corporate bonds is less clear as they become relatively less attractive compared to municipal bonds, but more attractive compared high dividend paying stocks.

After Federal Tax Yields Comparison 2012

Municipal Bond IG Corporate Bond High-Dividend Stock
Yield (Typical) 2.0% 3.5% 2.5%
Federal Tax Rate ‘12 0% 35% 15%
After Tax Yield 2.0% 2.27% 2.08%

After Federal Tax Yields Comparison Under Existing Law For 2013

Municipal Bond IG Corporate Bond High-Dividend Stock
Yield (Typical) 2.0% 3.5% 2.5%
Federal Tax Rate ‘13 0% 43.4% 43.3%
After Tax Yield 2.0% 1.98% 1.41%

As the table shows, if nothing is done to change the tax code, municipal bonds become very attractive compared Investment Grade Bonds or High Dividend paying stocks. To get the higher after tax-yields, investors will start buying up municipal bonds, pushing up their price and pushing down their yields. Under this scenario Municipal bond yields might drop by 0.2 to 0.4%.

 

Obama Has Expressed A Strong Interest In Capping The Municipal Bond Tax Deduction

Obama’s tax proposals for interest and dividend income does not differ from the existing law for 2013. However, President Obama has talked about limiting the ability to deduct the tax-exemption for wealthy taxpayers owning municipal bonds. Essentially, if more than 7% of a taxpayer’s income comes from tax-free municipal bond interest, additional interest from municipal bonds would be subject to federal income tax. In my opinion, if this proposal was passed it would reduce demand for municipal bonds somewhat , but not have a major impact on prices.

 

After Tax Yields Under Romney’s Proposal

Municipal Bond IG Corporate Bond High-Dividend Stock
Yield (Typical) 2.0% 3.5% 2.5%
Federal Tax Rate ‘12 0% 25% 15%
After Tax Yield 2.0% 2.63% 2.08%

Romney’s proposal would make the after-tax yields of corporate bonds extremely attractive compared to municipal bonds and high dividend paying stocks. Should the Romney proposal pass, one would expect corporate bond prices to rise nicely and municipal bond prices to fall a little.

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Comments

  1. Frank says

    Capping the municipal bond tax deduction would have a huge downward effect on the value of municipal bonds and is an extraordinarily stupid idea. Through the tax-exemption, the federal government continues to provide critical support for the development and maintenance of essential facilities and services, which it cannot practically replicate by other means. Without the tax-exemption, state and local governments would pay more to raise capital, a cost that ultimately would be borne by taxpayers, through reduced infrastructure spending, decreased economic development, higher taxes or higher user fees.

    Existing bonds would fall in value. Municipal financing costs would rise, as investors require more yield to make up for lost tax benefit. Fewer municipal projects would be funded, or local property and income tax rates would rise, with other knock-on effects.

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