Enhancing after-tax returns with municipal bonds

Text size: aA aA aA
Municipal bonds have long been considered well-suited for high-net-worth investors because their income returns are generally free from federal income taxes and, in some cases, state and local income taxes.

Consider your tax situation

The increase in the maximum capital gains tax rate in late 2012 made municipal bonds more attractive to top earners. The maximum tax on long-term capital gains remains at 15% for most Americans, but rises to 20% for those with taxable incomes of over $400,000 ($450,000 for joint filers). In addition, a new surtax on net investment income, which includes capital gains, results in an overall top long-term capital gains tax rate of 23.8% for high-income taxpayers. What's more, municipal bonds' pre-tax yields historically have averaged approximately 31% below those available on Baa-rated corporate and 10% below government issues of comparable maturities, making them an attractive investment for investors in the 25% tax bracket or above.Footnote 1
Your financial advisor can assist you in comparing the after-tax yield on tax-exempt municipals with that of taxable issues. The accompanying table shows the taxable-equivalent yield for different yields and federal income tax brackets. These figures provide a general reference, but may not be applicable to your situation. While income from corporate bonds is generally fully taxable, income from U.S. government bonds is exempt from state income taxes. If you are in a high-tax state or locality that also exempts interest income from locally issued municipal bonds (known as double or triple tax-exempt bonds), the calculation of taxable-equivalent yield for those issues must be adjusted to reflect the state and local income tax savings.
Other tax considerations you should be aware of before investing in municipal bonds include:
  • Capital gains on municipal bond investments are taxable as short- or long-term capital gains, depending on how long you have held the investment
  • Income from certain bonds, known as private-activity bonds, must be reported as taxable income if you are subject to the alternative minimum tax. These bonds, which are used to finance projects such as sports stadiums or airport terminals that provide some benefits to private companies, are identified as private-activity bonds in their prospectuses.
  • Municipal bonds generally are not held in tax-deferred retirement accounts since the investment returns in these accounts are taxed as ordinary income upon withdrawal

The tax efficiency of managed municipal bond investments

Individuals may invest directly in individual bonds, in municipal bond mutual funds, or through a privately managed account. Managed investments offer the advantages of professional management and, in the case of mutual funds, greater diversification. However, actively managed mutual funds may generate taxable short- and long-term capital gains, offsetting some of the potential tax advantages of municipal bond investing.
Some funds may have accrued capital losses in previous years that can be carried forward and applied against future capital gains. A privately managed account combines the benefits of professional management and direct ownership of the underlying securities. One advantage of investing in municipal bonds through a privately managed account is the potential tax savings that can result from coordinating the recognition of losses in the bond portfolio to offset taxable gains on other investments that you may have.
If you have large, unrealized gains in stock positions, for example, short-term losses on your municipal bond investments may offer opportunities to realize some of the gains on your stock holdings. Using a technique known as "tax loss harvesting," a private account manager may sell some bonds when prices are depressed, resulting in realized capital losses. The proceeds of the sale are then reinvested in different bond issues, and the losses may be used to offset realized gains on an equal amount of appreciated stock. Because longer-term bonds tend to be more volatile than shorter-term issues, an investor using this strategy may prefer a portfolio that includes long-term bond issues.
Taxable vs. tax-free yield
Tax bracket
10%
15%
25%
28%
33%
35%
39.6%
Tax-Exempt yield
Taxable-Equivalent yields
2%
2.2%
2.4%
2.7%
2.8%
3.0%
3.1%
3.3%
3%
3.3%
3.5%
4.0%
4.2%
4.5%
4.6%
5.0%
4%
4.4%
4.7%
5.3%
5.6%
6.0%
6.2%
6.6%
5%
5.6%
5.9%
6.7%
6.9%
7.5%
7.7%
8.3%
6%
6.7%
7.1%
8.0%
8.3%
9.0%
9.2%
9.9%

Portfolio management strategies

Municipal bond prices are sensitive to changes in interest rates and to demand and supply factors. The low-interest-rate climate of the past few years made borrowing especially attractive, both for new projects and for refinancing older debt.
Bond investors are generally hurt by higher interest rates, as bond prices fall when interest rates rise, and benefit when interest rates fall. However, most long-term municipal bonds are callable by the issuer prior to their maturity date at face value. An issuer is likely to call bonds that carry interest rates above the current market rate. The bond's call provisions will specify the earliest date that the bond may be called, which may be as soon as 10 years after the issue date. If you purchase individual bonds for more than their face value, it's important to consider whether the bond offers an attractive yield to the call date, rather than maturity.
Like other types of bonds, municipal bonds carry credit risks. For example, a slowing economy generally creates wider price spreads between high- and medium-quality municipal bonds, offering professional managers opportunities to potentially add incremental returns through careful security selection. High-yield and variable-rate municipal issues offer higher yields than general obligation or revenue bonds but also pose greater risk of default. Combining investments from several states and investing in insured bonds are two strategies that can help reduce the credit risk of a municipal bond portfolio.
Value of $1,000 Municipal Bond Investment, 1983-2015
Enhancing after tax returns
Source: ChartSource®, DST Systems, Inc. Municipal bond yields based on the 12-month trailing yield of the Barclays Municipal Bond index. Growth of a bond investment based on a $1,000 initial investment tied to the returns of the Barclays Municipal Bond index, and assumes reinvestment of all income received. Does not consider the effects of taxes. For most taxpayers, municipal bond interest is not subject to federal taxation. Your situation may be different; contact a tax or legal professional for further information. It is not possible to invest directly in an index. Past performance is not a guarantee of future results. Copyright © 2016, DST Systems, Inc. All rights reserved. Not responsible for any errors or omissions. (CS000147)

Footnote 1 Source: The Federal Reserve. Based on 20-year yields, yields of Baa-rated corporate bonds and General Obligation municipal yields over the 50-year period ended December 31, 2015.

Source: Standard & Poor's. Based on all funds tracked by Morningstar as of December 31, 2012, classified as domestic tax-exempt bond funds with a history of at least three years.

Important Note on Bond Funds: Return of principal is not guaranteed. Bond funds have the same interest rate, inflation, and credit risks that are associated with the underlying bonds owned by the fund. Generally, the value of bond funds rises when prevailing interest rates fall and falls when interest rates rise. There are ongoing fees and expenses associated with owning shares of bond funds.

Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa. Income from investing in municipal bonds is generally exempt from Federal and state taxes for residents of the issuing state. While the interest income is tax-exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the Federal Alternative Minimum Tax (AMT). Single-state municipal bonds pose additional risks due to limited geographical diversification.

© DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions.

This material is authored by DST Systems, Inc. and was not authored by Merrill Edge. Assumptions, opinions and estimates constitute judgment from DST Systems, Inc. as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue.

Because of the possibility of human or mechanical error by DST Systems, Inc. or its sources, neither DST Systems, Inc. nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall DST Systems, Inc. be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

Banking products are provided by Bank of America, N.A. and affiliated banks. Members FDIC and wholly owned subsidiaries of Bank of America Corporation.

Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

AR8W6QR9-EXP04202018