Tax Day: DO NOT Make These Mistakes

Dear Rich Lifer,

Are you an investor looking for higher returns and lower taxes? Municipal bonds may be the answer to your prayers.

Just this year, investors have put $39 billion into municipal-bond mutual funds, according to data compiled by Municipal Market Analytics. This is the most amount of money funneled into such funds since 2008!

Municipal bonds, also known as munis, are debt securities issued by states and local governments to fund their daily activities or special projects such as the construction of highways, bridges, or schools.

They are generally free from federal taxes and state taxes in the issuing state. Because of this, upper-income individuals have increasingly prized muni bonds as a portfolio position.

From Sharp Decline to Peaking Demand 

Everywhere we look, we see the desire for municipal bonds reaching record highs! Current demand for munis is so high that Illinois, the only state to tap the Federal Reserve’s pandemic emergency-lending facility, recently sold three-year bonds at yields near 1%.

Why the upswing?

One reason could be due to President Biden’s tax change proposals, which would raise taxes on the rich. This is making municipal bonds more attractive to investors since they usually offer tax-free interest payments. 

Like Treasuries, municipal bonds are also considered safe investments because they are backed by taxes or payments on essential services like water. 

This new fervor for municipal bonds marks a sharp reversal from early pandemic trends when investors dumped munis at huge discounts due to fear over the coronavirus. In March 2020, municipal bond funds hemorrhaged an outstanding $28 billion.

This resulted in city and state borrowing to freeze. Many predicted that it would cause tax collections to plunge and financial stress to result in waves of defaults.  

Defaults did climb, but investors returned after April when the Federal Reserve cut interest rates and began buying billions worth of bonds. These actions by the Fed lifted the municipal bond market and the economy. 

As a result of the federal government stimulus, tax collections largely exceeded expectations, and state and local governments lifted revenue forecasts for this year. The passage of the $1.9 trillion stimulus bill in March resulted in Moody’s Investors Service raising its outlook for state and local governments to “stable” from “negative.” 

Other analysts are also optimistic about the future of municipal bonds, like Bank of America analysts who noted that the muni market is entering “a new golden decade of strong growth and strengthening credit quality.” 

Muni Bonds Strong Performance 

Municipal bonds had stronger performance than other fixed-income assets during the larger bond-market decline that we witnessed earlier this year. 

According to Bloomberg Barclays data, munis returned 0.59% to investors this year through May 6, including price changes and interest payments. This beat a minus 3.22% total return on Treasurys and minus 3.1% on corporate bonds.

Some analysts believe these gains are driven by state and local government’s inability to sell bonds fast enough to match investor demand.  In 2020, bonds for new projects reached $252 billion, according to Refinitiv. This made it the biggest year for bonds since 2010 when a federal incentive program helped push the total above $270 billion. 

But bond sales are already outpacing the 2020 rate! 

According to Municipal Market Analytics, borrowers have sold $124 billion in new bonds this year as of Friday, May 7. Meanwhile, refinancings and money paid back to investors totaled around $131 billion. That has led to a $7 billion discrepancy, increasing demand for new bonds.

Finding a silver lining in the past year, Ben Watkins, director of bond finance for the state of Florida, states, “We have money raining out of the sky. We’re in a much better position now than if Covid hadn’t hit at all.”

Low Yields

Remember, yields fall when bond prices rise…

Matt Fabian, head of research at Municipal Market Analytics, notes, “There are just far more lenders than there are borrowers. That keeps municipal-bond yields pinned as low as you can go.”

Bloomberg Barclays data shows that the average yield on 10-year triple-A-rated munis was 0.82% at Friday’s close — less than 0.2 percentage point above the record low yield of 0.68% from February, in data going back to 1993. 

Proposed federal infrastructure spending could ease this discrepancy since local policymakers will be in a position to use more muni bonds for new projects. 

However, as we mentioned earlier, many experts also think that muni bond demand will increase even further if Mr. Biden’s plan to raise capital-gains taxes passes. In fact, USB analysts advised clients last week to consider buying munis over corporate bonds as one way to reduce taxable income.

Yields on 10-year triple-A-rated munis are currently around half of those on 10-year Treasury rates. Munis usually yield less than federal debt because of the tax advantage they provide. The current discount surpasses historical levels, a clear sign of investors’ continued desire for the debt.

Mr. Fabian of Municipal Market Analytics observes that low yields restrict the amount of income that investors can earn from holding muni funds after accounting for fees. In a booming economy, investors tend to be more inclined to go after riskier assets such as stocks over bonds’ fixed yields, which are considered a curb against volatility. 

And what of the booming economy, you ask?

Last Friday, we saw a hugely disappointing jobs report for April, which revealed that the U.S. added only 266,000 jobs last month. This was a big shock, considering economists had predicted that 1 million jobs would be created in the same timeframe. It also marked the weakest monthly gain since January.

However, there will be new earnings from Walt Disney Co. and DoorDash Inc. to be analyzed this week, along with fresh data on consumer prices and retail sales. 

Will the muni bond craze continue? Only time will tell. As always, it’s best to consult with your financial expert when deciding how much you should allocate to municipal bonds.

To a Richer Life (and Retirement),

The Rich Life Roadmap Team

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