Wealthy Americans eyeing potential tax increases are helping drive record amounts of money into municipal bond funds.
In the first six months of 2021, U.S. municipal bond funds attracted an estimated $56.9 billion in net new money—the most for any first half of the year going back to 1992, according to data from Refinitiv Lipper.
Advisers to high-income investors say the potential for higher taxes has been a focus of conversation in recent months, drawing attention to munis.
Municipal bonds typically offer interest payments that are exempt from federal income taxes and sometimes from state taxes in the state where the bond is issued. State and local governments, along with institutions such as hospitals and universities, issue municipal bonds to raise money for projects that include building schools and paving roads.
Many affluent households fear that President Biden and the Democratic-controlled Congress will raise taxes. On the campaign trail, Mr. Biden proposed raising the top individual income-tax rate to 39.6% from 37%, among other changes to taxes for high-income households and corporations. Democrats won control of Congress—but narrowly—and recently have been working to decide which tax proposals they should try to pass. That change in the top individual rate is one of the proposals that has the broadest support among Democrats and appears more likely to occur than other proposals.
“Taxes are a huge concern for clients right now,” said Anderson Lafontant, senior adviser at Los Angeles-based Miracle Mile Advisors. “It’s really increasing the demand for municipal bonds, because they have tax-free interest.”
Some investors may also have looked to rebalance their portfolios after a dramatic rally in the stock market ballooned positions in U.S. equities. Households looking to restore their risk exposure to its level before the S&P 500’s 16% advance in 2020 may have redirected some of those gains into fixed income, including municipal bonds. U.S. stocks have continued to gain, sending the S&P 500 up 15% in 2021.
While the return on munis hasn’t been much lately, it has been better than that of other highly rated bonds. A Bloomberg Barclays municipal bond index has returned 1.8% to investors this year, including interest and price appreciation, as of Thursday, compared with a 0.4% loss on a Bloomberg Barclays index of U.S. corporate investment-grade bonds, according to FactSet.
‘There’s only a few things you can do to invest to generate tax-free income. Munis are the most obvious, the most liquid and the most safe.’
“Muni returns will be muted in the near term, but the tax efficiency cannot be beat, and that is what is most attractive today,” said Alex Chaloff, co-head of investment strategies at Bernstein Private Wealth Management. “There’s only a few things you can do to invest to generate tax-free income. Munis are the most obvious, the most liquid and the most safe.”
Among high-yield bonds, municipals also are outperforming: An ICE BofA index of high-yield municipal bonds had a year-to-date total return of 5.9% through Thursday, compared with a total return of 4% for an ICE BofA index of high-yield corporate bonds, according to CreditSights.
Higher confidence in the health of state and city finances has bolstered the case for munis.
As the coronavirus pandemic shut down large portions of the U.S. economy, cities and states suddenly expected that revenue shortfalls would lead to serious budget problems. Investors withdrew an estimated net $46.1 billion from municipal bond funds in March 2020, according to Refinitiv Lipper.
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But in many places, the fiscal damage turned out to be less severe than anticipated. Federal aid for households and businesses supported consumer spending, and the economy picked up more quickly than expected.
Aid from Washington also included $350 billion for state and local governments to pay for pandemic-related costs, fill revenue shortfalls and fund water, sewer and broadband projects.
“You have the credit quality, you have the fiscal stimulus, you have the potential for higher taxes,” said
director of tax-free fixed income at Lord Abbett & Co. “Even though we’re in a low-rate environment, it’s making investors really comfortable investing in municipals.”
—Richard Rubin contributed to this article.
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