How tax filing season is boosting munis
WASHINGTON – Tax filing season is bringing a realization among at many high income families that federal tax reform has increased the attractiveness of ownership of tax-free municipal securities, say portfolio managers.
The Tax Cuts and Jobs Act has eliminated or reduced many federal tax write-offs, leaving the muni exemption as one of the few ways to shield income from taxes.
That message has circulated throughout the municipal bond market ever since the tax changes were enacted in December 2017 but is only now sinking in for many people who are seeing the impact in dollars and cents on their tax returns.
“I think it is driving a relative value proposition in the muni market,” said Dan Heckman, U.S. Bank national investment consultant based in Kansas City, Mo. “I think it’s going to be more apparent as we move through the remaining part of this tax season.”
Mark Paris, chief investment officer and head of municipal strategies at Invesco, said, “I think for a lot of people, when they start to put pen to paper, they are going to find that their taxes are not as low as they thought they were going to be post tax reform.”
That’s particularly true for residents of high tax states such as New York, New Jersey and California who are facing a $10,000 federal cap on the deduction for state and local taxes.
Paris, who lives in New Jersey, is among the people with a higher federal income tax bill this year than a year ago.
“What you are seeing as we get into February, March and April, I think a lot of individual investors are going to look to munis as a safer haven for taxes a little bit more than they thought last year,” he said. “The rhetoric out of Washington was that everybody’s taxes are going to be lower and I think that probably caused a little bit of a lull in municipal demand last year.”
The household sector owned 42.2% of the nation’s $3.83 trillion in municipal securities in the second and third quarters of 2018, according to Federal Reserve data. Fourth quarter 2018 data is scheduled for release March 7.
Paris predicts 2019 to be “a more normalized year where flows come back into municipal bonds pretty well and where, I think, investors are going to continue to look for tax exempt yields.”
Eric Kazatsky, portfolio manager for Clark Capital Management in Philadelphia, said tax reform has amplified the awareness of the value of municipal bonds even among households that already had them in their portfolio.
The overall bond market has been rallying since the start of the year and investors also want to lock in yields, Kazatsky said. But a third element is that people "want to protect more of their income going forward,” he said.
“We’re already seeing positive flows this year, an uptick from where we would normally see January and February,” said Kazatsky.
Many of Kazatsky’s clients live in California, which saw an increase in demand for state munis in 2018. His firm is making the argument to their California investors that they might consider buying munis from other states and hold only about 75% California bonds because there are good buys elsewhere.
Jonathan Law, vice president and portfolio manager at AAM, said that's what happened with California spreads last year and is starting to happen with New York munis.
“Much like everyone and their mothers have predicted, it’s definitely starting to play out,” Law said.
Spreads also are tightening in New Jersey and Massachusetts, according to Law. “All of the higher tax states are definitely seeing higher demands,” he said.
The portfolio managers also foresee the higher demand from individual households continuing.
“We don’t think interest is munis is going to wane this year and it isn’t going to wane going into the 2020 election,” Beckman said.
Paris agreed, saying, “I think it should be a positive trend at least into the next election."