Can Municipal Bonds Help Boost Your After-Tax Income?

Michael Helmuth is chief portfolio manager at Northwestern Mutual Wealth Management Company.

The vast majority of individuals who invest in the municipal bond market are looking to generate some sort of after-tax return. These bonds are designed for that purpose due to the fact that interest generated by tax-exempt municipal bonds is generally exempt from federal income taxes, unlike that of nearly every other fixed income investment. This explicit tax exemption was put into place as far back as 1913 with the passage of the Revenue Act, a landmark federal law signed by President Woodrow Wilson that fundamentally transformed the United States' fiscal system by establishing the first modern federal income tax and dramatically reducing import tariffs.

Then came the Tax Reform Act of 1986. Widely considered the most comprehensive overhaul of the U.S. tax code since the income tax’s inception, the bipartisan law enacted under Ronald Reagan fundamentally shifted the tax burden from individuals to corporations while dramatically simplifying the rate structure for individuals. It also significantly increased the appetite for municipal bonds, primarily by eliminating most other tax-exempt investments, leaving municipal bonds as one of the few remaining ways for investors to earn tax-free income. Unlike corporate bonds and other taxable fixed income bonds, municipal bonds are issued by a vast number of unique issuers—as many as between 50,000 and 70,000, according to an estimation by the Municipal Securities Rulemaking Board (MSRB). This compares to approximately 1,500–1,800 unique corporate issuers in the U.S., as reported by the U.S. Securities and Exchange Commission (SEC).

Given the wide range of bond issuers across the U.S., smaller, specific issuers tended to struggle to get their debt offerings sold at reasonable yields, even with the federal tax exemption. While many states offered state tax exemptions with the 1913 Revenue Act, more were implemented throughout the 20th century. Over 36 states now provide state tax exemption for interest earned on bonds issued from their own state and municipalities. This act of exempting in-state bonds from taxation while taxing out-of-state bonds was upheld in a 2008 Supreme Court case, Department of Revenue of Kentucky v. Davis.

Today, municipal bonds remain a favored investment given their tax-advantaged status, allowing investors to keep a larger portion of their earnings compared to taxable alternatives like corporate bonds or Treasurys.

As illustrated by the chart below, there is a break-even when it comes to purchasing municipal bonds. Purchasing in-state bonds will actually yield less than purchasing out-of-state bonds and subsequently paying the state tax.

The incremental yield required for an investor to be indifferent to the state tax exemption, otherwise known as the “hurdle rate,” depends on their specific state’s marginal income tax rate and the current market yield. The table below lists, by largest issuing state, which yields on five- and 10-year bonds are high enough that their after-tax returns are equal to the tax-free return of an in-state bond.

This table shows that while state tax exemptions can be advantageous, it is not a decision that occurs without analysis. This mathematical example can also be extrapolated to credit, as each of these yields is derived from the Bloomberg Fair Value curve for each state. This curve is derived from general obligation bonds issued by that state.

There are a few things to notice in the chart:

First, the market for bonds has many factors that form its pretax yield, including the in-state tax exemption. In short, the market adjusts for these tax exemptions before the end user can benefit, creating thinner opportunities than many individual bond buyers would suspect. For instance, Texas, Florida and Washington bonds—from an index point of view—are almost mathematically indifferent for a California and New York resident to own at the state income tax level.

Secondly, the chart does not show the benefits of actually diversifying across economic boundaries. Limiting investments—especially those as conservative as investment-grade municipal bonds—to a finite tax code, economic landscape and possibly limited industry can increase risk in portfolios. While constructing portfolios of individual municipal bonds, we take the client’s state residence into consideration throughout the life of the portfolio, constantly searching for opportunities to increase after-tax returns. Therefore, we state that we provide a state tax “preference” rather than a mandate when managing portfolios.

Finally, it is worth noting that the data in this chart reflects a singular point in time. Issuance, flows, political changes as well as credit concerns or improvements are all factors that will make a specific state—or a specific bond, for that matter—move relative to others. As portfolio managers managing client accounts, we measure and monitor those changes daily as we select bonds for client accounts.

The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. No investment strategy can guarantee a profit or protect against loss. Past performance is no guarantee of future results. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. Information and opinions are derived from proprietary and nonproprietary sources. To learn more, click here.

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