A positive outlook for municipal bonds

Daniel Lippincott, The Daily Record Newswire

Now that the dust has settled on the 2012 presidential election, investors are faced with the strong probability of higher tax rates in 2013 and beyond. In fact, the likely expiration of the “Bush Tax Cuts” combined with the implementation of an additional 3.8 percent “Obamacare” tax will significantly erode investors’ after-tax returns.

While these additional taxes certainly make dividend stocks less appealing, interest from municipal bonds remains fully tax-free.

When comparing municipal bonds to Treasury bonds, corporate bonds and dividend stocks, it is useful to calculate the tax equivalent yield of the tax free bond. The tax equivalent yield is calculated by dividing the tax-free municipal bond yield by one, minus the tax rate.

Currently, the tax equivalent yield of a 20-year AA rated 3.25 percent municipal bond is 5 percent. Assuming the highest marginal rate on investment income rises to 43.4 percent, the tax equivalent yield of the same 20-year AA rated 3.25 percent municipal bond would rise to 5.74 percent.

The tax equivalent yield of the municipal bond outpaces almost all comparable investments.

Another positive for municipal bonds is that they remain cheap by historical standards when comparing their yields to Treasury and corporate bonds. Currently, 10-year AAA municipal bonds yield approximately the same as a 10-year Treasury.

The historic ratio of 10-year AAA municipal to 10-year Treasury yields is 90 percent. This means that if the muni-treasury yield ratio returned to the historic average, the 10-year municipal bond would rise by more than 10 percent in price. Municipals are even cheaper when compared with corporate bonds. Currently 10 year municipal bonds yield 112 percent of comparable corporate bonds, well above the historical average of 80 percent.

Municipals bonds have also been less volatile than Treasury and corporate bonds over time. Over the last 15 years, municipal bonds have experienced only 70 percent of the volatility of comparable Treasury and corporate bonds. This is even more impressive when you consider that an investor subject to the highest marginal tax bracket would have experienced superior after-tax returns in municipal bonds over the same time period.

The perfect storm of higher taxes, superior relative valuation and decreased volatility make municipal bonds very attractive as we move into 2013. It is important to note that not all municipal bonds are created equal so investors are cautioned to do their homework. As always, if you are interested in investing in municipal bonds, but you are not sure where to start, do not hesitate to consult your financial advisor.

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Daniel Lippincott is a senior tax sensitive manager/director of investment personnel for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.

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