Source: Bloomberg 2016
While rising interest rates can cause negative price returns in fixed income over the short-term, the price movement can be partially offset by yields from higher reinvestment rates. Hence, investors with a long-term time horizon will eventually benefit from rising rates as the income component of return increases. While rates move upward from historic lows, short-term price volatility can be expected in fixed income markets; however, the combination of current yields and reinvesting at higher rates will ultimately benefit investors over the long run.
With a new Administration in office and Republican-controlled Congress, the probability of tax reform is high. After President Donald Trump’s victory, market participants questioned if the tax exemption for municipal bonds would cease to exist. Eliminating the tax-exempt status of municipal bonds has been a topic of conversation historically, but has proved to be an uphill battle and to date, municipal bonds have always maintained their tax-exempt status through the years. President Trump also alluded to the U.S. Conference of Mayors that he supports maintaining the tax-exempt status on municipal bonds.
One of the main tax reforms still on the table is decreasing the number of individual tax brackets from seven to three and reducing the highest marginal tax rate from 39.6% to 33%. Since individual investors mainly use municipal bonds to reduce their tax burden, if the tax brackets are reduced, municipal bonds become less attractive due to the loss of after-tax value. Even with the proposed tax reduction, municipal bonds still remain relatively attractive in comparison to Treasury bonds today.
For comparison, we will use the muni/Treasury ratio to show the attractiveness of municipal bonds versus Treasury bonds. The muni/Treasury ratio takes the yield of municipal bonds and divides it by the yield on Treasury bonds. If the yield for municipal bonds and Treasury bonds were equal, the ratio would be 100%, indicating municipal bonds are more attractive given the same pre-tax yield but higher after-tax yield. The below example assumes a tax rate of 39.6% in which Treasuries become more attractive on an after-tax basis when the ratio moves below 60%.
