Predicting what tax rates will be next year or beyond isn't easy.
Neither is generating after-tax income amid low interest rates. One way to go about increasing after-tax income is to minimize the impact of taxes.
This may sound simple, but it isn't simple-minded.
Municipal bonds are generally exempt from federal, local and state taxes.
An investor in the highest federal tax bracket of 39.6%, who also pays the 3.8% Medicare surcharge, would generate a tax-equivalent yield of 3.9% on a muni investment yielding just 2.2%. Investors in the upper tax brackets and living in states with relatively high taxes such as California and New York can benefit even more from the tax treatment of municipal bonds.
As we head into the home stretch before the elections, muni bonds also appear to be attractively valued at most maturities along the yield curve, as compared with Treasury securities. Their favorable tax status isn't being fully discounted in the marketplace, a dynamic that may provide a cushion should rates rise at some point.
As of Oct. 25, the Chicago Mercantile Exchange's FedWatch tool calculates the market as discounting a 78% probability of the Federal Reserve raising rates by its Dec. 14 policy meeting.
A commonly held view by MainStay Investments and our independent boutiques is that the Fed will slowly increase rates over time.
This time of the year often provides a good entry point for long-term muni-bond investors. Historically, October has been a poor month for muni-bond returns.
Issuers come to market just as trading desks try to reduce their exposures, altering the short-term balance between supply and demand. The good news is that October has historically set the stage for a more favorable seasonal pattern in November through February, all else being equal.
Past performance, though, isn't a guarantee of future results.
The muni-bond market is one in which doing one's homework can pay off. There is a lot to keep up on these days when investing in muni bonds.
For starters, muni pensions remain a concern with most states having unfunded liabilities. As a result, revenue-supported bonds with dedicated liens on pledged revenue such as airports, educational services, health care facilities and toll roads might be attractive options.
Additionally, changes to money market fund rules on Oct. 14 have led to a rise in short-term muni-bond yields, altering relative values along the yield curve. Our muni-bond team sees value in bonds maturing in less than a year and bonds maturing in 10 to 18 years, while the 1 to 10 year portion of the yield curve remains less enticing.
The shift in the yield curve might lessen the efficacy of the popular strategy of laddering bonds in a positively sloped yield curve environment, whereby, the investor rolls down the curve by selling the bonds before they mature in an effort to profit from rising prices. However, in this environment, there may be less roll to be gained.
Those who are seeking after-tax income shouldn't wait until April to address taxes. Avoid tricky taxes now with tax-exempt muni bonds.