Municipal Bond Tax Exemption Investment Primer

Transcription

1 WEALTH MANAGEMENT INVESTMENT RESOURCES APRIL 20, 2015 Municipal Bond Tax Exemption Investment Primer JOHN M DILLON Managing Director Morgan Stanley Wealth Management John.Dillon2@morganstanley.com MATTHEW GASTALL Executive Director Morgan Stanley Wealth Management Matthew.Gastall@morganstanley.com In this report: Municipal Bond Tax Exemption Apples-to-Apples Comparison With Taxable Bonds Taxable-Equivalent Yield Calculation Relative-Value Metrics Threats to the Tax Exemption Federal Taxable-Equivalent Yields Federal Tax Bracket (%) Tax-Exempt Yield 1.00% specific investments. Source: Morgan Stanley Wealth Management Municipal Strategy of April 17, 2015 Compelling Comparisons: The Value of the Municipal Bond Tax Exemption It s not how much you earn, but how much you keep. That adage explains the appeal of investing in tax-exempt municipal bonds, whose interest is exempt from federal income taxes and quite often state and local taxes as well. Even though their nominal yields are typically lower than those on US Treasuries and corporate bonds, municipal bond yields may provide investors with a higher return when taxes are taken into account. While an investor s tax bracket is important in determining whether to invest in municipal bonds, so are the yields in comparison with taxable bonds. Historically, 10-year municipals have yielded about 83% of what benchmark 10-year US Treasuries have yielded. That percentage, known as the relative-value ratio, fluctuates depending on market conditions. In fact, the ratio is now elevated in other words, bonds currently trade cheaper than they otherwise should, in our view. Indeed, we believe the ratio could be lower because the market environment suggests potentially greater investor demand. The American Taxpayer Relief Act of 2012 actually raised marginal tax rates for wealthy individuals and many states have also raised their respective tax rates in recent years. On the other hand, there have been discussions in Congress about tax reform, which could impact municipal bond prices if it limits the value of the tax exemption. Given limited progress on tax reform thus far and a presidential election looming in 2016, we find it unlikely that the municipal bond tax exemption will be diminished this year. However, we estimate a 15% to 20% probability of such risk in the coming years. The net effect of this political and calendar timing is that municipal bonds are likely to remain attractive on a relative-value basis until this tax code risk is removed, as we expect it eventually will be. Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance. Please refer to important information, disclosures and qualifications at the end of this material.

2 Compelling Comparisons: The Value of the Municipal Bond Tax Exemption It s not how much you earn, but how much you keep. That adage explains the appeal of investing in tax-exempt municipal bonds, whose interest is exempt from federal income taxes and quite often state and local taxes as well. Even though their nominal yields are typically lower than those on US Treasuries and corporate bonds, municipal bond yields may provide investors with a higher return when taxes are taken into account. Given that the value of a municipal bond s tax exemption depends on the investor s marginal tax rate and often, the state of residence tax-exempt municipal bonds may not be suitable for all investors. As a rule of thumb, the higher the investor tax bracket, the greater the potential benefit from tax exemption. Though most municipal bonds are tax exempt, some are taxable and others pay interest that is subject to the alternative minimum tax. For our purposes, we will be referring to federally tax exempt municipal bonds unless otherwise noted. While an investor s tax bracket is important in determining whether to invest in municipal bonds, so are the yields in comparison with taxable bonds. Historically, 10-year municipals have yielded about 83% of what benchmark 10-year US Treasuries have yielded. That percentage, known as the relative-value ratio, fluctuates depending on market conditions. In fact, the ratio is now elevated in other words, bonds currently trade cheaper than they otherwise should, in our view. Indeed, we believe the ratio could be lower because the market environment suggests potentially greater investor demand. The American Taxpayer Relief Act of 2012 actually raised marginal tax rates for wealthy individuals and many states have also raised their respective tax rates in recent years. On the other hand, there have been discussions in Congress about tax reform, which could impact municipal bond prices if it limits the value of the tax exemption. Given limited progress on tax reform thus far and a presidential election looming in 2016, we find it unlikely that the municipal tax exemption will be diminished this year. However, we estimate a 15% to 20% probability of such risk in the coming years. The net effect of this political and calendar timing is that municipal bonds are likely to remain attractive on a relative-value basis until this tax code risk fades or is removed, as we expect it eventually will be. Apples-to-Apples Comparisons The benefits of the municipal bond federal tax exemption are best illustrated by using an apples-to-apples comparison of what an investor would need to earn before taxes on a comparable taxable security to match the yield offered on a tax-free municipal bond. To do so, we use the taxable-equivalent yield (TEY) of the municipal security, which is calculated by taking the tax-free yield, and dividing it by 1 minus the investor s federal tax bracket. TTT = Tax-Free Yield (1 Tax Bracket) For example, suppose an investor in the 39.6% federal tax bracket is considering a bond with a 1% tax-free yield, which is currently available on a four-year AAA municipal bond. Using the formula, we put 1% in the numerator, and for the denominator, we put 1 minus the tax bracket, The result is 1.66%, which is what a fully taxable bond would have to yield in order to match the tax-free yield. Similarly, if the investor is in the 28% bracket, the tax-equivalent yield falls to 1.39%. Figure 1 shows TEYs in the 25%, 28%, 33%, 35% and 39.6% federal tax-brackets for a variety of tax-exempt yields, with the necessary yield required on a comparable taxable bond increasing for investors in the highest tax brackets. Figure 1: Federal Taxable-Equivalent Yields Federal Tax Bracket 25% 28% 33% 35% 39.6% Tax-Exempt Yield 1.00% 1.33% 1.39% 1.49% 1.54% 1.66% specific investments. For more information about the risks to hypothetical performance, please see the Risk Considerations section at the end of this report. Source: Morgan Stanley Wealth Management Municipal Strategy as of April 17, 2015 This analysis addresses only the federal tax exemption. Exemptions from state and/or local government taxation may be applicable and vary by state, which requires additional TEY calculations (see Figure 2, page 3). The average state tax rate is approximately 5.5%, which makes the state exemption quite valuable in many cases, but particularly so for those investors who reside within states/cities that possess the highest nominal tax rates. These areas include California, New Jersey and New York. Considering that these three are higher-tax and higher-issuance states, California, New York and New Jersey investors should consider making in-state bonds their primary municipal holdings, Please refer to important information, disclosures and qualifications at the end of this material. 2

3 since the high issuance affords investors plenty of choices with which to build diversified portfolios. Figure 2: State and Local Taxes, Where Applicable, Can Drive TEYs Higher Tax-Exempt Yield Florida* California** New York City** 1.00% 1.66% 1.91% 1.90% Measuring Relative Value Municipal bonds have historically traded at a discount to what the tax exemption would otherwise suggest. This is especially the case today. The easiest way to isolate the value offered in the municipal asset class is by examining the relative-value ratio, which is a measure that compares the municipal yield to that of a corresponding federally taxable US Treasury security. For the 10- year maturity, this ratio historically averages around 83% (see Figure 4: Relative-Value Ratio Since % *Florida has no state income tax. **California and New York City TEYs are calculated using their highest income tax rates. specific investments. For more information about the risks to hypothetical performance, please see the Risk Considerations section at the end of this report. Source: Morgan Stanley Wealth Management Municipal Strategy as of April 17, Year Relative Value Ratio Average Since 1981 Finally, municipal bond interest is also exempt from the 3.8% Medicare surtax recently implemented in association with the Patient Protection and Affordable Care Act, which further bolsters tax-equivalent yields (see Figure 3). This levy hits various forms of investment income including taxable bond interest for individuals, trusts and estates. Figure 3: Medicare Surtax Exemption Can Bolster TEYs Tax-Exempt Yield Florida* California* New York City** 1.00% 1.77% 2.06% 2.04% *Florida has no state income tax. **California and New York City TEYs are calculated using their highest income-tax rates. specific investments. For more information about the risks to hypothetical performance, please see the Risk Considerations section at the end of this report. Source: Morgan Stanley Wealth Management Municipal Strategy as of April 17, '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 Source: Morgan Stanley Wealth Management Municipal Strategy, Thomson Reuters as of April 17, 2015 Figure 4). The market is considered to be trading weaker than the US Treasury market when ratios rise, and is considered to be trading stronger when ratios decline. Keep in mind, these mathematical averages will vary depending upon the maturity and sector of the yield curve, though this fundamental dynamic remains constant. Threats to the Tax Exemption Much of the discussion on muni tax changes has centered on a 28% cap of certain exemptions/exclusions, a proposal introduced by the Obama administration in September As currently configured, the cap would essentially limit the value of select exemptions municipal bond income included to what an investor in the 28% bracket would experience. Investors in higher tax brackets would be required to remit the difference between their rate and 28%. For example, an investor in the 39.6% bracket would be required to remit 11.6% (39.6% %). We believe the municipal market has since traded weaker due to the presence of these threats, as the 10-year relative-value ratio relationship has averaged a notably higher 98% of comparable US Treasuries since the cap plan was floated versus the 83% historical average. Please refer to important information, disclosures and qualifications at the end of this material. 3

4 Considering that 2016 is a presidential election year, we believe that the likelihood of any such changes in the near term is significantly diminished; however, we cannot rule out the possibility that such proposals could be back in the news or even enacted in the future. As previously noted, we assign a relatively low 15%-to-20% probability for any such diminution of the municipal exemption in the coming years. Also, it is important to stress that we believe the greatest impact of such modification would be on the tax treatment of tax-exempt interest and the subsequent trading behavior (price volatility) in the municipal market, rather than on the actual creditworthiness of the issuing entity. Nonetheless, investors should be aware of these current challenges and take them into consideration. When implemented prudently to meet investment goals, purchasing municipal securities can be a sound strategy for investors who seek potential current income, tax efficiency and wealth preservation. Please refer to important information, disclosures and qualifications at the end of this material. 4

5 Risk Considerations Hypothetical Performance General: Hypothetical performance should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. Hypothetical performance results have inherent limitations. The performance shown here is simulated performance not investment results from an actual portfolio or actual trading. There can be large differences between hypothetical and actual performance results achieved by a particular asset allocation. Despite the limitations of hypothetical performance, these hypothetical performance results may allow clients and Financial Advisors to obtain a sense of the risk / return trade-off of different asset allocation constructs. Investing in the market entails the risk of market volatility. The value of all types of securities may increase or decrease over varying time periods. This analysis does not purport to recommend or implement an investment strategy. Financial forecasts, rates of return, risk, inflation, and other assumptions may be used as the basis for illustrations in this analysis. They should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. No analysis has the ability to accurately predict the future, eliminate risk or guarantee investment results. As investment returns, inflation, taxes, and other economic conditions vary from the assumptions used in this analysis, your actual results will vary (perhaps significantly) from those presented in this analysis. The assumed return rates in this analysis are not reflective of any specific investment and do not include any fees or expenses that may be incurred by investing in specific products. The actual returns of a specific investment may be more or less than the returns used in this analysis. The return assumptions are based on hypothetical rates of return of securities indices, which serve as proxies for the asset classes. Moreover, different forecasts may choose different indices as a proxy for the same asset class, thus influencing the return of the asset class. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Also, municipal bonds acquired in the secondary market at a discount may be subject to the market discount tax provisions, and therefore could give rise to taxable income. Typically, state tax-exemption applies if securities are issued within one s state of residence and, if applicable, local tax-exemption applies if securities are issued within one s city of residence. The tax-exempt status of municipal securities may be changed by legislative process, which could affect their value and marketability. A taxable equivalent yield is only one of many factors that should be considered when making an investment decision. Morgan Stanley Wealth Management and its Financial Advisors do not offer tax advice; investors should consult their tax advisors before making any tax-related investment decisions. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. Disclosures The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors, including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors. Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, Please refer to important information, disclosures and qualifications at the end of this material. 5

6 including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan Stanley Wealth Management has no obligation to provide updated information on the securities/instruments mentioned herein. The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor s individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies and other issuers or other factors. Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley Wealth Management does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. This information is not intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not acting as a fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as amended in providing this material. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice. Each client should always consult his/her personal tax and/or legal advisor for information concerning his/her individual situation and to learn about any potential tax or other implications that may result from acting on a particular recommendation. This material is disseminated in Australia to retail clients within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N , holder of Australian financial services license No ). Morgan Stanley Wealth Management is not incorporated under the People's Republic of China ("PRC") law and the material in relation to this report is conducted outside the PRC. This report will be distributed only upon request of a specific recipient. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors must have the relevant qualifications to invest in such securities and must be responsible for obtaining all relevant approvals, licenses, verifications and or registrations from PRC's relevant governmental authorities. If your financial adviser is based in Australia, Dubai, Germany, Italy, Switzerland or the United Kingdom, then please be aware that this report is being distributed by the Morgan Stanley entity where your financial adviser is located, as follows: Australia: Morgan Stanley Wealth Management Australia Pty Ltd (ABN , AFSL No ); Dubai: Morgan Stanley Private Wealth Management Limited (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at Professional Clients only, as defined by the DFSA; Germany: Morgan Stanley Private Wealth Management Limited, Munich branch authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Bundesanstalt fuer Finanzdienstleistungsaufsicht; Italy: Morgan Stanley Bank International Limited, Milan Branch, authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority, the Banca d'italia and the Commissione Nazionale per Le Societa' E La Borsa; Switzerland: Bank Morgan Stanley AG regulated by the Swiss Financial Market Supervisory Authority; or United Kingdom: Morgan Stanley Private Wealth Management Ltd, authorized and regulated by the Financial Conduct Authority, approves for the purposes of section 21 of the Financial Services and Markets Act 2000 this material for distribution in the United Kingdom. Morgan Stanley Wealth Management is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the Municipal Advisor Rule ) and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule. This material is disseminated in the United States of America by Morgan Stanley Wealth Management. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. This material, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC Morgan Stanley Smith Barney LLC. Member SIPC. Please refer to important information, disclosures and qualifications at the end of this material. 6