Talk of a Flat Tax Has Muni Bonds Out of Favor
Sometimes, the fate of investments seems to hinge more on political events than economic ones. Now is one of those times for municipal bonds and the mutual funds that hold them.
Proposals in Congress to scrap the current tax system in favor of a flat tax has dampened investor enthusiasm for munis. Under a flat-tax scenario, the interest payments made by cities, counties and state governments on their bonds would probably lose their tax-exempt status, undercutting the primary rationale for buying municipal investments.
Secondary factors weighing on municipals include memories of poor performance in 1994 and tough competition for investor dollars from this year’s booming stock market.
Already, these influences have shown up in the prices and yields of muni bonds and bond funds. Whereas the yields on long-term U.S. Treasury bonds have dropped by eight-tenths of percentage point since early April, boosting prices correspondingly, yields and prices on municipal securities have been mostly flat, says Jim Grabovac, portfolio manager of the INVESCO Tax-Free Long-Term Bond Fund in Denver.
Consequently, triple-A rated munis now yield only 10% less than what Treasuries yield on a nominal basis, before adjusting for the tax-exempt factor. Munis normally yield 15% less and recently had been as much as 20% below, making them a comparative bargain today in the minds of some observers.
“Munis are cheap by historical standards,” says Sheila Amoroso, lead manager of the Franklin High-Yield Tax-Free Income Fund in San Mateo, Calif.
To appreciate the discrepancy, you need to evaluate muni and Treasury yields on an equal footing. Long-term, highly rated municipals currently pay about 6.2% on average. Because their interest skirts federal taxes, that’s equivalent to a taxable bond paying 8.6% for someone in the 28% federal bracket and 10.3% for a person paying taxes at a top rate of 39.6%.
Munis pay lower nominal yields than other types of bonds because they alone skirt federal taxation. Treasury interest avoids state taxes, but this is a comparatively minor benefit, even in high-tax states such as California. Besides, muni interest also is tax-free for residents of the state in which a bond was issued.
In fairness, municipal investments still have had a decent 1995, despite recent sluggishness. The typical national muni-bond fund returned 8.8% from Jan. 1 through July 31, reports Morningstar Inc. of Chicago.
But that’s not as good as the average 9.8% gain for corporate-bond funds or the 9.9% advance for Treasury portfolios over the same period. The above figures include both interest yields and capital gains on the bonds held. Muni fund returns in August were flat.
If you’re an income-oriented investor, the question of whether to buy munis at today’s prices and yields depends on whether you think a flat-tax system will become a reality. Amoroso doesn’t believe it will.
“People are starting to realize that you’d have to give up a lot, such as mortgage-interest deductions for homeowners, to get this,” she says. “A lot of special-interest groups would be affected, and they will be getting out their side of the story.”
In the meantime, muni investors can take heart from a favorable supply situation, says Grabovac. Local and state governments will probably issue less than $160 billion or so in new bonds in 1995, making it a second year of moderate activity compared with the $295 billion worth of bonds that came to market in 1993 and the $250 billion issued in 1992.
“Few people outside of the industry are aware of this drawdown of supply,” he says.
As an added plus, Grabovac feels the bond market in general is cheap, reasoning that yields on a variety of bonds are generous compared to the inflation rate.
Whether they realize it or not, shareholders in muni-bond funds have always assumed a fair amount of legislative risk--reflecting the possibility that a tax-law change could wipe out the main benefit offered by their investments. This year, that danger has come home to roost.
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The Stein Roe Capital Opportunities Fund of Chicago completed a 2-for-1 split Aug. 25. The fund’s per-share price dropped in half, while the number of shares doubled. There were no income-tax consequences.
Stein Roe pursued the split to bring its share price in line with those of competing funds. “We want to ensure that our daily [price] movements are not exaggerated, so that the fund doesn’t appear more volatile than it seems,” says spokesman Thomas Butch.
The no-commission fund ([800] 338-2550) has placed in the upper half of aggressive-growth portfolios over the last five years.
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The Mutual Fund Education Alliance, an association of 33 no-commission fund families, has issued an updated version of its “Investor’s Guide to Low-Cost Mutual Funds.” The publication provides performance, fee and other information on more than 850 portfolios.
The guide costs $7. Investors can order it with a check or money order sent to the Mutual Fund Education Alliance at 1900 Erie St., Suite 120, Kansas City, MO 64116-3465.
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Average Muni Yields
California municipal bonds pay higher average rates than generic muni bonds nationwide. The tax-equivalent rate, taking into account the tax benefit for a resident of the state, is calculated below for someone at the 28% marginal federal tax rate and a 9.3% state tax rate.
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California muni bonds Generic Maturities (face value) (tax equiv.) U.S. munis Five-year 4.62% 7.38% 4.44% Seven-year 4.87 7.78 4.71 10-year 5.17 8.26 5.06 30-year 6.24 9.97 6.10
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Sources: Public Securities Assn. (PSA) and Bloomberg L.P. Yields for maturities beyond 10 years represent a callable bond. The yields are for a round lot ($250,000 or above). Several municipal bond funds labeled “California” still invest in out-of-state bonds, which could affect state tax break.
