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Why Tax-free Bonds May Be More Appealing Under Barack Obama

As this election season came to a close, markets were still reeling and recession fears loomed in many of the world’s leading economies. Our sense is that many Americans voted November 4 with one eye on the ballot and the other on their checkbook balances, savings and retirement accounts, and investment portfolios.        

Some voters no doubt gave credence to the many academic studies focusing on the relationship between markets and the president’s party affiliation. Longitudinal research has indicated that equity returns historically flourish under Democratic administrations and bonds generally do better under Republican administrations.

Of particular interest to us, however, are studies suggesting that these relationships are less true in recent times (i.e., since 1981) than in earlier times. For example, a 2005 presentation by two Boston-based professors of finance reached the following conclusion: "The impact of U.S. presidential elections on stock and bond prices has diminished over time and is no longer statistically significant."

Despite this finding, the professors caution investors against deciding that "presidential election outcomes are a matter of indifference." Their rationale is that markets are unpredictable and that, while not "statistically meaningful," large cap stocks have had slightly higher average returns when the Oval Office is occupied by a Democrat and bonds have had the economic edge under Republicans.

We agree that outcomes matter, but for a different reason: during the 2009-2013 presidential term, the Bush tax cuts are set to expire and this can have a big impact on how much investment income individuals get to pocket after taxes. In a higher-tax environment, the yields generated by tax-free investment vehicles—such as one of the 18 municipal bond funds we manage—become even more attractive relative to the yields on taxable alternatives.

For this reason, Reid & Associates encourages muni bond investors to maintain a long-term perspective. We believe that the election of Barack Obama as the country’s 44th president should not be seen as a mandate for making dramatic shifts in individual portfolios. Successful investors, we have found, allow income to compound over time to maximize the benefits of investing in muni bond funds.

Our opinion, by the way, would have been the same even had John McCain been victorious. During the campaign, he announced his intention to extend the 2001 and 2003 tax cuts, most of which are set to expire at the end of 2010. Most pundits, however, agreed that a Republican president would likely face insurmountable opposition from Congress on this issue and that tax rates would instead rise.

President-elect Obama campaigned to allow the tax cuts to expire, meaning the top federal tax brackets are expected to shift to 36% and 39.6%, from 33% and 35%, respectively, starting January 1, 2011. As a result, we expect tax-free municipal bonds, which have offered significantly higher yields in recent months than taxable Treasuries of similar maturities, to become even more attractive.

For a taxpayer currently in the 33% bracket, a muni fund or other taxfree investment yielding 5% provides as much after-tax income as a taxable investment yielding 7.5%. If the tax rate rises to 36%, the taxable investment would need to yield more than 7.8% to provide more income than the same muni fund. Of course, the market conditions that have depressed the prices of many municipal bond funds have also created some appealing buying opportunities for investors.

Tax equivalent yields (TEYs), or what a taxable investment would have to yield to match a range of tax-free yields, under two tax scenarios. If the Bush tax cuts expire, the top federal tax rate would rise to 39.6%, from 35%, for taxpayers earning more than $357,700. The next highest bracket—for single filers earning more than $164,550 and joint-return filers earning more than $200,300—would face a 36% tax rate, up from 33%. Income figures are based on 2008 tax brackets.

The figures highlighted in the table and text use 2008 federal tax rates and brackets as well as the higher tax rates that are anticipated once the Bush tax cuts expire. The calculations assume that the tax rate shown applies to the change in taxable income resulting from a switch between taxable and non-taxable investments and that the investor is not subject to the federal alternative minimum tax (AMT). Your actual tax rates will depend on your income, investments and deductions. You should consult your tax advisor regarding current tax legislation and how it may affect your personal financial situation.

These calculations are for illustrative purposes only and are not intended to depict or predict any fund’s performance. The comparison results would vary if different tax rates were used (for example, if state and local income taxes were factored in).

Yields in the hypothetical examples are shown net of any fund charges, fees or expenses. When comparing the performance of mutual funds, investors should use each fund’s standardized yield, which is based on net investment income for a 30-day period.

We also believe muni bonds and muni bond funds should attract investors concerned about the tax rates on future capital gains and dividends. If the Bush tax cuts expire, taxes on long-term capital gains would range between 10 and 20%, depending on the taxpayer’s tax bracket, and dividends would be taxed as ordinary income, as they were between 1954 and 2003.

Senator McCain campaigned on the promise of maintaining the 15% rate on long-term capital gains and dividends, while President-elect Obama said he would increase the rate to 20% for individuals making more than $200,000 a year and couples making more than $250,000 a year. During the campaign for the presidency, we realized that either proposal made tax-free income sound like a better alternative.

No matter what actually transpires in Washington, we believe muni bonds will become increasingly attractive to investors seeking to keep more of their investment income. Market conditions since August 2007 have sharply reduced prices of many municipal bonds (that’s a positive for buyers) and yields have been staggering (a positive for investors of every stripe).

We encourage yield-seeking investors to confer with their financial and tax advisors periodically to re-articulate their long-term financial objectives and refine their asset allocations with these objectives in mind.

However, we caution investors against trying to "time" municipal bond market movements or trying to align their portfolios to various predictions about how and when this presidential election will affect current market conditions and the economy. No matter how unified Americans are in their hopes for greater prosperity and economic growth, we believe it would be a mistake to pin one’s investment strategies to events that are, by nature, uncertain.

Investors eager to participate in the nation’s future success, we believe, are well advised to consider municipal bonds, which will certainly continue to provide essential financing for a broad array of infrastructure needs. Whether you measure success in terms of community building or tax-free income streams, we believe you’ll find this approach highly rewarding. 

Muni Bond Ideas

"RMUNX" Oppenheimer Rochester Muni Bond Mutual Fund

"NNY" Nuveen Closed End Muni Bond Fund

"MUB" iShares S&P National Muni Bond ETF

Please contact your financial advisor if you are interested in any of these ideas or if you would like a list of other municipal bond funds available through Reid & Associates LLC.

Individual state municipal bonds are also available at Reid & Associates LLC. Please call to find out the current rates and maturity dates.

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