In addition to the historical comparison, current breakeven tax rates are likely to be particularly low compared to actual tax rates going forward since the recent fiscal cliff “fix” has increased marginal rates for upper income households. In addition, the 3.8% Affordable Care Act (ACA) Net Investment Income Tax is now in effect for investors holding income-generating securities in their portfolios.
So, why are we seeing this big gap between breakeven tax rates and effective tax rates? As Matt has noted on the iShares blog, part of the explanation is that liquidity and supply issues in the muni market last year coupled with concerns that the muni tax exemption may be at risk has driven some investors to look elsewhere for yield. This has opened up a potential valuation gap between munis and other taxable fixed income instruments.
What is the bottom line for investors? This comparison chart should help demonstrate that muni yields are attractive for investors facing a tax rate this year that is similar to or higher than the one they experienced in the last few years. This is the case even when compared to corporate securities of similar maturities and credit rating. Indeed, given the higher tax rates of 2013 one would have to believe that the muni tax exemption would have to be reduced quite significantly — far beyond what has been on the table in the various fiscal negotiations — to change the basic conclusion that muni yields appear attractive not just compared to Treasuries but also across a broader range of fixed income instruments.
Daniel Morillo, PhD, is the iShares Head of Investment Research.
[1] Data is from Bloomberg. Data is obtained as an index of yields, in percent, at the monthly level (the Bond Buyer Index is weekly, so the last week of every month in that case) and averaged across 6-month rolling periods.
[2] See “U.S. Municipal Bond Defaults and Recoveries,1970-2011” from Moody’s investors service.