Bonds: Tax-Free, Taxable, Or Both?

The Problem
Perhaps one of the most confusing decisions facing an investment advisor today is whether some clients with taxable accounts should purchase taxable or tax exempt bonds for their high quality bond portfolios. This decision is straightforward for clients that earn large amounts of taxable income (over $326,450) which puts them into the maximum tax bracket of 35%. Municipal bonds are clearly the most appropriate investment for them. However, this decision is much more difficult when the client has invest able funds of $1-$3 million and very little (if any) taxable income coming from other sources. In these cases, the investment chosen “drives” the amount of taxable income that the client earns as well as their marginal tax bracket. For example, assume the client has an investment portfolio of $3.5 million and taxable income of $100,000. The portion the advisor allocates to the high quality bond portfolio is $800,000. Most advisors struggle with the appropriate mix of bonds for these clients. “Should I buy taxable bonds, tax exempt bonds, or perhaps a mix of both?” What is the proper way to make this investment decision?

Interest rates are constantly changing and so is the relationship between taxable and tax exempt securities along the yield curve. The changes in both interest rates and the inter-market relationships are important factors in the decision making process. The combination of changing rate levels as well as changing income levels makes this decision appear to be challenging.

Marginal Tax Rates
Tax-managing bond portfolios begins with a careful examination of the client’s marginal tax rate. This rate will determine the suitability of different fixed income securities for each client. This rate is dependent on the type of filing of the taxpayer and the level of income the client earns after all deductions are subtracted.

Filing Status
A single person has a higher marginal tax rate for the same level of income than a married person filing a joint return.

Income
We are referring to taxable income after all allowable deductions have been taken. This is the number from line 43 of the 1040 return. This income number can be used to determine the client’s marginal tax rate. Securities available in the tax-exempt and taxable markets can then be compared on an after-tax basis. These after-tax rates are then compared by maturity to determine what works best for each client. These rates and relationships are changing on a daily basis. Frequently, the portfolio is optimized by using a combination of longer maturity munis and shorter maturity agencies.

More emphasis needs to be placed on determining each client’s marginal tax rate. This may be difficult because of the many variables involved which causes this rate to be a “moving target.” Superior bond portfolio performance depends on improving this process.

Ratio of Munis to Agencies
The muni yield curve can be compared to the taxable yield curve to determine the percentage that each of the maturities trade compared to taxables. Munis traditionally trade at lower ratios in the shorter maturities and higher ratios in the longer maturities. The chart below shows the historical ratio of a 10 year muni compared to a 10 year U.S. Treasury bond. The average for the last 3 years is 86%. Recently, this ratio has fallen to 82.4%. This has an impact on after-tax yields and means that an investor needs to be in a higher tax bracket (86%-82.4%=3.6%) for munis to be attractive. This change is about equal to the amount of state tax a married person filing jointly would pay in the state of Arizona.

One way of looking at the current value of a muni compared to a taxable security is to take the ratio (munis/taxable's) and subtract it from 1. We can do this for all maturities along the curve and we get a chart like the one titled Muni/Agency Ratio which shows tax efficiency below. If we compare this graph to the client’s marginal tax rate (the blue line), we can see that munis will be attractive to the investor whenever this ratio is lower than the marginal tax rate. Munis are only attractive to this investor when he begins to look at maturities in the 5 year part of the curve. Munis would be attractive to all investors in the 35% bracket or higher. The advantage of this approach is that the tax-free/taxable ratio is constantly changing. We can monitor the ratios up and down the yield curve and compare them to the client’s marginal tax rate to determine which fixed income security is best suited for his/her needs.
Conclusion

Each individual investor has a unique tax situation. Returns may be optimized when more attention is paid to the marginal tax rate of each client. This requires familiarity with the client's tax return, and an understanding of the client's tax situation.