Clinton’s Plan Bolsters Case for Tax-Frees
As expected, President Clinton is turning out to be a pretty good salesman for tax-free mutual funds.
Municipal bond portfolios had been popular well before Clinton won the election, but now that he has formally proposed higher taxes, the funds are likely to get a further marketing boost.
For more and more people, the dilemma isn’t whether to invest in mutual funds holding bonds issued by cities, counties, states and various municipal agencies. Rather, it is a question of which types to buy.
Funds that own a national assortment of muni bonds enjoy an edge in that their portfolios are better diversified, but the interest they spin off avoids federal taxation only. By contrast, funds that invest solely within a single state, such as California, pay yields exempt from U.S. and state taxes, at least for local residents.
California is a vast market for tax-free funds, and the national and single-state varieties sell well here in terms of overall volume.
But the California-only portfolios are clearly the investments of choice among Golden State residents, outselling the national funds by a margin of nearly 4 to 1, according to recent figures compiled by the Investment Company Institute in Washington.
This preference can be explained by the relatively high tax rates imposed by Sacramento. A Californian in the top federal and state brackets now faces a combined effective rate of 38.6%, according to Zane B. Mann, publisher of the California Municipal Bond Advisor, a newsletter based in Palm Springs.
On a California muni fund paying 5.5% tax-free, that’s equivalent to a taxable yield of 9%.
Assuming Clinton’s top 36% federal bracket goes into effect (but ignoring any possible surtax above that), wealthy Californians would face a combined maximum 43% rate, Mann says. For these people, the same 5.5% yield would be worth 9.7% on a taxable-equivalent basis.
The top combined bracket, which includes an 11% state income tax rate, applies only to the wealthiest Californians--those earning more than $207,200 (single) or $414,400 (married, filing joint returns), Mann says.
But even the large number of people earning between $29,873 and $103,600 (single) or $59,746 and $207,200 (joint) still face a fairly stiff 9.3% California burden, Mann says.
“With these tax rates, the yields on state-only funds come out ahead every time,” he says.
For example, somebody in the 28% federal and 9.3% California bracket (a combined 34.7%) would need to find a taxable investment yielding 8.4% to match a California muni fund paying 5.5%.
Combined effective rates, by the way, are adjusted to reflect the fact that state taxes are deductible on federal returns. That’s why 9.3% plus 28%, in the above example, adds up to 34.7% rather than 37.3%.
Incidentally, a 5.5% yield is what California muni bond portfolios were paying on average in December, the most recent period tracked by Lipper Analytical Services of Summit, N.J.
As noted, the national funds are better diversified than California-only portfolios, which could be important if a large number of municipalities get into financial trouble. Mann doesn’t see this happening. “We are in deep trouble in California, but most bonds won’t go into default,” he says. “Given the size of our economy, there’s no reason to sell your California-only funds.”
Mann does predict that defaults will rise in California this year, but he notes that only four muni issues--accounting for 0.2% of the value of outstanding bonds--went belly-up in 1992.
Still, Californians wanting double-exempt income but worried about the state’s economy could purchase insured muni funds. This way, some or all of the bonds held by your fund are protected by large, independent consortiums in the event that interest or principal isn’t paid.
Notably, insurance does not guard against bond price fluctuations. You pay for protection in the form of lower yields, but today the price of such coverage is fairly modest. The average insured California fund yielded 5.2% in December, according to Lipper.
“Insurance has come down dramatically since the mid-1970s. It really doesn’t cost much at all,” says Andrew M. McCullagh Jr., who runs eight muni funds with $500 million in assets for the Voyageur group of Minneapolis, including an insured California portfolio.
Mary-Kay Bourbulas, co-manager of two national muni portfolios for Strong Funds of Milwaukee, instead cautions investors to pay attention to possible interest rate risk. That’s because muni yields, in nominal terms, are at meager levels. “Now’s not the time to lock in a low rate for 30 years,” she says.
Bourbulas suggests that investors stick with muni funds that hold intermediate rather than long-term debt. These bonds, which generally come due in four to 12 years or so, exhibit less price volatility yet still pay reasonably competitive rates. California intermediate funds yielded 5% at last count, according to Lipper.
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The Love Affair Continues
President Clinton’s proposal to raise tax rates most likely will further whet Californians’ appetite for the tax-free income available on municipal bond funds.
Because of California’s high personal tax rates, “single-state” funds that invest exclusively in California bonds are especially popular here. These pay interest that avoids both federal and state taxes.
Here’s how recent sales for key mutual fund categories break down for California and the nation as a whole.
* California Sales: Stock Funds: 30.6% Taxable Bond and Income Funds: 52.1% National Municipal Bond Funds: 3.5% California Municipal Bond Funds: 13.8% U.S. Sales Stock Funds: 32.3% Taxable Bond and Income Funds: 50.7% National Municipal Bond Funds: 9.5% Single-State Municipal Bond Funds: 7.5% Source: Investment Company Institute. Data excludes money market funds.
