July 23, 2010
President Barack Obama could go down in history as one of America’s greatest municipal bond salesmen.
While the president isn’t moonlighting as a bond peddler, he has proposed tax increases, starting next year, for millions of high-income Americans. Whether Congress will agree remains uncertain. But if the president wins approval for his plan, many wealthy investors will have an additional incentive to buy tax-exempt bonds issued by state and local governments.
The president has proposed higher taxes for singles making more than $200,000 and married couples filing jointly who make more than $250,000. The top federal income tax rate, now 35 percent, would rise to 39.6 percent, effective in January 2011. Obama also would increase taxes on capital gains and most corporate dividends for upper-income investors. For example, the top long-term capital gain rate, now 15 percent, would rise to 20 percent, starting next year. Supporters say these increases would raise additional revenue and help reduce the nation’s budget deficits.
There will be even more incentives to buy municipal bonds, or “munis,” beginning in 2013. That’s when high-income investors will get hit with additional tax increases under the health care law enacted earlier this year, which includes higher taxes on investment income, such as capital gains and dividends.
Thus, this could be a good time for investors seeking tax relief to re-examine the $2.8 trillion municipal bond market, where issuers range from large states to small water and sewer districts. Muni-bond enthusiasts say fears about a possible tidal wave of municipal bond defaults are vastly overblown, and that munis generally offer good value — especially for upper-income taxpayers living in high-tax areas. “Credit risk so far is more headline risk than anything else,” says Douglas Schoen, a wealthy investor who lives in New York City and a longtime fan of tax-exempt bonds.
But with many state and local governments facing major budget woes, investors need to be especially careful about which types of bonds or bond mutual funds they buy. Credit ratings are still a factor, even though the biggest rating agencies have drawn heavy criticism in recent years. Many experienced bond investors, including Schoen, stick to buying only bonds with the highest credit ratings, such as double-A or above. Many also expect interest rates to rise in coming years and thus are limiting their bond purchases to short-term and medium-term issues, such as those due in three to five years.
Analyzing muni bonds can be a daunting task. For example, there is a difference between "general obligation" bonds (those backed by the issuer's full faith and credit) and "revenue bonds" (typically backed by revenue from a specific project or facility being financed). Investors should check whether a bond can be “called,” or redeemed by the issuer prior to the scheduled final maturity date, which could cut off the income stream much earlier than expected. While many investors choose individual bonds, others prefer buying shares of bond funds for the professional management, diversification and convenience.
Growing numbers of investors have been turning to municipal bonds and bond funds in recent years. According to Internal Revenue Service data, more than 6.4 million individual income tax returns for 2008 reported tax-exempt interest income. That was up from 6.3 million for 2007 and 4.5 million for 2005. The returns for 2008 reported tax-exempt interest income of about $72.6 billion.
“The higher-tax story resonates with investors,” says Phil Condon, managing director and head of the municipal bond department at DWS Investments, a unit of Deutsche Bank Group in Boston.
State and local taxes are likely to be a big issue in coming months, as legislators in many states consider tax increases, as well as spending cuts, in response to budget pressures. Many investors in high-tax areas, such as New York City, favor bonds issued within their home state. Or they invest in “single state” mutual funds, which buy only bonds issued within one state. The reason is simple: taxes. If a New York City resident buys a New York bond, the interest typically is free from federal, state and local income tax. That's why they're known as "triple tax-free." If that New Yorker buys a California bond, the interest would be subject to New York State and New York City taxes.
Warning: Not all municipal bonds are tax-exempt. Some types pay interest that is taxable. Also, some bonds that aren't subject to regular income tax are subject to the alternative minimum tax, or AMT — a parallel tax system that operates under different rules than the regular tax system. These are known as "AMT bonds."
Before buying any munis, investors should ask for details on the issue's tax status, or get a copy of the bond prospectus and read it carefully. There’s a handy introduction to the highly diverse world of muni bonds, including a glossary and representative muni-bond prices and yields at www.investinginbonds.com, a website of the Securities Industry and Financial Markets Association.