iBankCoin
Tokyo based, expat Cape Bretoner. Learning to live in a de-leveraging world. Better suited to the crusades. CFA & FRM charter holder. Disclaimer: @Firehorsecaper reminds investors to always due their own due diligence on any investment, and to consult their own financial adviser or representative when warranted. Any material provided is intended as general information only, and should not be considered or relied upon as a formal investment recommendation.
Joined Jun 23, 2015
73 Blog Posts

MUNI DEBT: SALT IN THE WOUND FOR HIGH TAX STATES

tRump’s GOP tax plan is not sitting well with the high tax, blue leaning states of California (11.4% rate for State and Local Taxes, aka SALT), Connecticut (11.4% SALT), New York (12.6%) and New Jersey (12.3%). These four states account for 22% of the US population and 23% of US GDP. I frankly expected a higher percentage GDP wise, with so much of the vast contiguous states dedicated to energy production (1000 gallons a second in demand) and animal husbandry (9 ounces a day per capita).

With the proposed changes to the US tax code, removing the deduction of SALT payments from ones Federal tax bill going forward, the effective tax rate for the wealthy will be increasing significantly on passage of the bill in close to its current form. This will greatly enhance the attractiveness of municipal debt and has resulted in a stonking rally in muni bonds this week. Early innings with respect to the rally, unless the federal deduction for SALT survives in the final drafting. Rolling back SALT deductions offsets approx. 1/3 of the $1.3tln “hole in the bucket” left by the proposed GOP corporate and individual tax cuts (largely paid for by the 3% resultant GDP growth). The rally moves in muni credit will likely be muted on the heels of the ongoing Puerto Rico default/debacle, hence there is time to put in the work and do the analysis required to come up with a rational investment decision.

https://ibankcoin.com/firehorsecaper/2016/04/10/puerto-rico-the-spoils-of-war/#sthash.uTYSeX6D.dpbs

The initial read of Trump’s tax reform plans appeared to be hemlock for muni debt, driven largely by lower absolute tax rates, with the highest 39.6% (solo income >$418.4k, joint filer >$470.7k) bracket moving to 33%. With key tweaks to the tax reform plan on the deductions side, as many as 25.5% of taxpayers could see their taxes increase from current levels under the currently tabled tax reform plan. It appears the 39.6% bracket will likely be kept for those earning above 7 figures.

As an aside, NJ, post election, is expected to re-institute the millionaire tax for resident making > $1mm (2% effective surcharge on income > 1mm). In addition to the egregious existing taxes NJ levies, for no good reason other than winning geographic roulette in being commutable to NYC, one should expect a portion of NJ’s millionaires (7% of the population on net worth metric, much lower % on income) to pull up stake, taking a page out of Tepper (formerly #1 NJ taxpayer, now in Florida) playbook. With nine states credit watch negative, including NJ, a betting man would place odds on more downgrades than upgrades going forward.

For muni bond investors in the 4 high tax states profiled, there are a bevy of state specific funds that cater you your investment needs, if purchasing bespoke muni bonds is beyond your ken. The advent of on-line trading platforms is improving the state of play, but the bid/offer spreads on muni bonds is high, both outright and compared to taxable peers.

https://www.marketaxess.com/trading/municipal-bonds.php

Two funds with comparable scale and liquidity are BlackRock Muni Holdings New Jersey Quality Fund, Inc. ,MUJ  and Nuveen New Jersey Quality Municipal Income Fund, NXJ. The big daddy is a Vanguard offering, 4x bigger at $2bln +; Vanguard NJ Long-Term Tax-Exempt Inv., VNJTX, yielding 3.46% (Federal and NJ tax exempt) which may seem paltry, until you calculate the taxable equivalent basis (TEB). Speaking to investment income, a NJ taxpayer in the top tax bracket in all categories pays 39.6% in Federal tax, 8.97% in direct NJ State Tax and Obamacare 3.8% tax on investment income (muni bonds are exempt). Adding up this stack gets you to 52.4% in taxes, coincidentally the same as the Province of Ontario in Canada (ditto on distress, save the pension funding shortfall issue).  Vanguard, and other veritable institutional investors have online calculators for TEB for those not mathematically inclined.

In my rudimentary NJ example, the VNJTX yield is 3.46% and the denominator is 0.476, resulting in a taxable equiv. yield of 7.27%. A quick perusal of global fixed income markets will find many gobsmacked to realize how high a 7% taxable yield is in the current environment.

US state pensions remain woefully underfunded in aggregate (70% funding rate, > $1 tln unfunded) and the public pension gravy train keeps on chugging, at least for now. Even for a $18 trillion dollar US economy, so many debt tallies in the trillion plus club should give the non-billionaire adults in the room cause for pause, if not reflection. Student loan debt; $1.3 tln, auto loans $1.2 tln and credit card debt (“revolving”, at least in theory) $1.1 tln. Those reticent to buy NJ domiciled muni debt and or NJ dedicated funds can of course give NJ a wide berth from an investment perspective. The rub is that your tax exempt muni yield will be only federal tax exempt, not state tax exempt. Following on my previous NJ example, your TEB (aka, your taxable basis “bogey”) becomes 6.11% instead of 7.27%.

The same analysis should be done for potential muni investors in “the big 4”, NNCC, as you are spoiled for choice in terms of muni debt and/or state specific funds (mutual, closed-end and ETF forms) to choose from.

When things get really interesting, “cross over” buyers, those that can not use the US tax exemption, find it compelling to buy US muni credit versus other investment options available in their home market. I’m a holder of BlackRock Taxable Municipal Bond Trust, BBN in my IRA (the underlying bonds are taxable hence distributions, currently yield 6.75% is taxable in non tax sheltered accounts). Pension obligation bonds, issued by states attempting to improve their pension funding % (in lieu of also paring benefits, which other countries do on a near 50/50 basis, until fully “funded” from an actuarial perspective) are also taxable.

With equities “off the leash”and vol compressed due to medicated markets, munis have a valid place in the asset allocation for US taxable investors (likely a multiple of gold and/or crypto). The US municipal bond tax exemption is one of the few near-free lunches on offer in global investable fixed income markets.

Keen to address any questions, as I know this space well. Follow me on twitter @firehorsecaper. Good to be back.

Caleb Gibbons, CFA

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5 comments

  1. tonka

    Always like reading your stuff. You ever end up getting a borrow on Home Capital? That gap up over $20 the second day after the Buffet news was a MONEY short setup.

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    • firehorsecaper

      $HCG could never get the borrow as too much of the float was controlled by just a few institutional investors. There is always another trade.

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  2. boyaj

    Caleb, as usual, great article per usual. Very informative. I’ve got a question/comment though about the availability of tax-exempt muni debt. With the House’s proposal to eliminate tax-exempt private activity bonds, do you believe there will be a strong demand for currently available tax-exempt funds? Thanks so much.

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  3. firehorsecaper

    Many things may be tweaked before they get tax bill through but what seems to be a constant is scrapping the the SALT deduction and getting rid of both Pre-refunded and Private Activity Bonds. There will be a thumb on the scale in both directions; more demand and less muni supply. Some have estimated supply could shrink by 35% at the high side a year out with passage of the bill. The tail will not wag the dog mind you …… if bonds shit the bed, muni bonds are still effected (even though they outperform taxable debt). Due diligence is key, but there are pockets of value in the space. JCG

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    • boyaj

      Appreciate the insight. You’ve got much more experience than I do in this space, but this is one of the areas I focus on, specifically for 501c3’s so the PABs and pre-refunded elimination is something I am keeping a close eye on. Pre-refunded appear to be out the window, although those aren’t a major concern of mine due to interest rates ticking up and many organizations already using their “one shot”. But it’s the PABs that I’m keeping a watchful eye on, as House voted to have them out, but first draft Senate bill kept them in. This suggests this will be one of the major negotiated points. Of course, the organizations can still issue taxable munis with higher yields, but that’s not attractive to them due to higher interest cost…but if income tax rates fall to a certain point, there may be an incentive for investors to demand taxable munis. This is stream of conscious, but appreciate your knowledge.

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