A Tax Rise Might Boost Muni-Bond Products

Unless you’ve been waiting in line for Madonna’s new book, you’re probably aware that tax rates stand a good chance of rising after the election--at least for wealthier investors.

Front-runner Bill Clinton has proposed raising the top marginal rate to 36% from 31% for couples making more than $200,000 a year. A possible Clinton surtax on millionaires could push the top effective rate close to 40%.

There’s even a chance that some personal tax rates could go up in the aftermath of a surprise Bush or Perot victory Tuesday. The federal deficit, after all, isn’t getting any smaller.

However the chips may ultimately fall, any move toward higher tax rates makes municipal bond funds more attractive. These investments are among the few left paying interest that avoids federal and, in some cases, state taxes.

“Any increase in tax rates would be a big boost to muni bonds,” says Robert Dennis, who manages three municipal funds with $2.3 billion in combined assets for Massachusetts Financial Services of Boston. “The level of taxation is what determines the value of tax-exempt bonds.”

Yet the municipal market hasn’t rallied much lately despite the possibility of a post-election tax hike.

Overall, the funds were up a respectable 6.7% (including both interest and capital gains) during the first nine months of 1992, according to Lipper Analytical Services. But corporate-bond portfolios did better and government funds nearly as well.

Looked at another way, top-quality munis are paying generous yields in relation to Treasuries, to which they’re often compared.

Normally, three-year munis yield only 79% of what Treasuries pay, but now those yields are up to 86%, according to Shearson Lehman Bros.

(The reason munis yield less than Treasuries, despite being riskier, can be explained by their greater tax exemption.)

Five-year municipals, which normally yield 75% as much as five-year Treasuries, are paying 81%. And 10-year tax-exempts yield 83% as much as 10-year Treasuries, compared to a normal ratio of 76%.

So why are muni yields so high at a time you would expect the bonds to be gaining in popularity? The answer is that other factors come into play.

In particular, a heavy supply of tax-free bonds has come to market this year, as cities, counties, states and municipal agencies rush to borrow or refinance at today’s attractive interest rates.

“Because of a recent deluge in supply, municipal securities are trading cheap to their Treasury bond counterparts,” write W. Stansbury Carnes and Thomas Gallagher, authors of a Shearson report on muni issues.

They predict that the supply pressures will abate soon, once the “wave of refinancing begins to dry up.” So far this year, according to Shearson, the supply of new muni bonds has already passed $228 billion, the single-year record established in 1985.

Supplies are especially heavy among general-obligation, or GO, munis, says Dennis. These are considered the more secure of the two main categories of munis because they’re backed by the taxing power of the issuing state or local government. Revenue bonds, by contrast, depend on money generated by a specific public project such as a toll road, hospital, sewer system or whatever.

A decade ago, GOs yielded about a percentage point less than revenue bonds, says Dennis, but the gap has since narrowed to one-quarter point. Investor demand for muni bonds has remained reasonably strong in recent years. But experts say they haven’t seen that extra push, perhaps because talk of higher tax rates--let alone a new President--is a bit premature.

“A lot of people won’t toss their money in until taxes actually go up,” says Rafael Costas, a senior muni-bond analyst for the Franklin Group of Funds in San Mateo.

Even with higher taxes, Costas warns, muni prices could get hurt if Clinton’s (or another President’s) economic agenda adds to the budget deficit and boosts economic growth to the point of being inflationary.

As it is, the gross domestic product for the third quarter grew at a better-than-expected 2.7% clip, suggesting that the economy is stronger than many bond investors had hoped, he says.

But assuming that you’re looking for tax-exempt income, this appears to be a reasonably good time to consider municipal bonds and bond funds. Fluctuating interest rates remain a constant threat, of course, but any easing of supplies or raising of tax rates--both of which are near-term possibilities--would help the market.

“Munis occasionally become attractive relative to Treasuries due to temporary supply and demand factors,” says Dennis. “But they always move back to equilibrium eventually.”