This year's higher taxes played a secondary role as demand for municipal bonds surged after April 15 tax deadline passed, according to analysts.
Analysts had predicted that demand for municipal bonds would increase in late April after investors in the highest tax bracket saw the impact of the Patient Protection and Affordable Care Act on their 2013 federal taxes, making munis' tax-exemption more appealing. While analysts acknowledge higher taxes did increase munis' attractiveness April 15, they said market conditions were the primary factor in ramping-up demand.
"The rally has more to do with lower benchmark treasury rates, supply shortage, cheap municipal-to-Treasury ratios, and investors chasing yields lower," Fred Bacani, Head of Fixed Income and Trading at Veritable LP in Newtown Square, Pa., said in an interview.
Investors' demand for municipal bonds has remained strong all year. Fund flows for all municipal bond funds were positive for 16 out of the 22 weeks so far this year, according to Lipper FMI.
Fund flows have remained positive for the last five consecutive weeks ending with the week ending June 5.
During this time fund flows have reached their highest levels in 2014 jumping to a lofty $943.23 million of inflows for the week ending May 7, and remaining above $600 million for the three following weeks. Before May 7 the most weekly inflow had totaled was $272.77 million for the week ending April 9.
The 2010 health care law affected tax returns this year by charging a 3.8% tax on net investment income for individuals and heads of households with an adjusted growth income of $200,000 or more, or married couples filing separately with an AGI of $125,000 or more, as well as other additional taxes such as a 0.9% Medicare tax on that tax bracket, according to healthcareact.com.
"There have been four straight weeks of inflows into muni funds since April," Ashton Goodfield, Head of Municipal Bond Trading for Deutsche Asset & Wealth Management, said in an interview Wednesday. "That could be a result of higher taxes in April."
Goodfield said that there may be other reasons behind the increased demand for municipal bonds.
"One way to measure the impact of tax rates on the muni market is to look at the correlation of changing tax rates and the valuation of munis compared to treasuries, and the correlation is not very high," she said.
"Many factors impact this relationship," she said. "There are a lot of things that go into the choice of whether to buy munis, taxable bonds or equities."
Bacani said that munis are the cheapest high-grade fixed income sector out there for high tax rate investors.
The spread between the triple-A 10-year benchmark general obligation bond to the benchmark 10-year Treasury note has compressed by 14.47 basis points to 86.97 from June 5, 2013 to June 4, 2014, according to Municipal Market Data Interactive.
"Municipal-to-Treasury ratios on the longer-end of the yield curve are still at 90-100% of Treasuries," Bacani said. "We haven't altered our investment decisions, given the higher tax rates, because munis were already the cheapest high-grade fixed income sector on an after-tax basis for high tax rate investors."
Analysts also said that municipal bonds attractiveness has increased because they are performing well this year. The Standard & Poor's municipal bond index show year-to-date returns of 5.83%.
"In a fairly dramatic way the equity market had such a strong run last year," Jim Colby, chief municipal strategist at Van Eck Global, said in an interview . "We said 'maybe we should be taking some profits [at the end of 2013] because we don't expect equities to perform like 2013. If you take profits what do you do with that cash? What market is attractive and what assets are attractive?' We have discovered munis."
Michael Schroeder, president and chief investment officer at Wasmer, Schroeder & Company, said that the profitability of municipal bonds can be seen by banks' and exchange traded funds' increase in municipal holdings.
"Normally banks are not attracted to munis unless they are profitable; these days they are," he said.
Colby said Van Eck Global began the year with seven municipal bond exchange traded funds.
"We began the year at an asset base of $1.7 billion, and are now at $2.1 billion year to date," he said.
Peter Hayes, managing director and head of the municipal bonds group at BlackRock, said in a press meeting Thursday that BlackRock believes higher taxes drove up demand for municipal bonds in recent weeks, but also said that the jump in fund flows is due to a variety of factors including this year's low supply.
"You do see fund flows pick up right around tax time which they did, and they have been increasing," he said. "Part of the increasing is due to the fact that it is getting harder for individuals to find bonds. How retail expresses their interest in munis always changes depending on the market environment."
Supply totaled $115.15 billion as of May 31 compared to $153.03 for the same period last year, according to data provided by The Bond Buyer and Ipreo.
Analysts do enforce the fact while higher taxes might not be the primary driver behind the demand for munis this year, increased taxes do make municipal bonds more desirable.
"There is not going to be one reason people increase their holdings in one asset class," Goodfield said. "When you combine high federal taxes with some states that have higher state taxes, it makes the appeal of munis even stronger."
Schroeder said a higher tax rate makes municipal bonds particularly attractive for top-income individual investors living in states with high taxes.
"People who live in states where the income tax rates are very high like New York and California will see demand, but those states are also heavy issuers of munis," he said. "You have to look in context of what the demand is."
Goodfield said that many California residents have expressed interest to Deutsche Asset & Wealth Management in California bonds.
"The effective rate [of California bonds] is around 50% for the highest rate payers," she said. "California's credit picture is better than it was a few years ago. The economy has stabilized in most areas of California."
Hillary Flynn is a reporter for The Bond Buyer.
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