Muni strategies for tax changes and volatile interest rates

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      By Jon Rocafort, CFA, Co-Director of SMA Strategies, Eaton Vance Management

      New York - Changing tax rates and new state and local tax (SALT) deduction caps have made tax-exempt interest income from muni bonds more compelling to investors.

      For example, municipal bond mutual funds saw net inflows of $11.2 billion in February, their largest monthly inflow since September 2009. Investors from high-tax states have helped drive the $18.9 billion of inflows to municipal funds so far in 2019 through February, according to Morningstar.

      Within these flows, we have seen two trends emerge. One is demand for state-specific muni strategies in response to lower SALT deduction caps. The second is interest in muni ladder strategies to provide more predictable, tax-free income in a volatile environment for interest rates.

      Demand for state-specific muni strategies

      The Tax Cuts and Jobs Act of 2017 introduced a $10,000 cap on the SALT deduction, which effectively raised investors' state tax rate. This has caused many investors in high-tax states to buy muni bonds by issuers from their own state in an effort to lower their tax burden.

      Interest from muni bonds is exempt from federal income taxes, but interest from muni bonds issued from the investor's own state is also generally exempt from state taxes.

      Muni ladder strategies

      Separately, a laddered approach to muni bonds may make sense for investors looking for consistent tax-exempt income.

      A laddered approach may provide the benefits of muni bonds -- predictable, tax-exempt interest income and price performance that is relatively uncorrelated with equities -- while also delivering the customization needed for an investor's unique circumstances.

      Laddering a muni bond portfolio involves equally weighting maturity exposure over a specified portion of the yield curve. A constant percentage of bonds mature, or roll out, each year. When this occurs, the proceeds are reinvested on the longer end of the ladder.

      Equally weighted ladders may also be defensive in a rising rate environment. As shorter bonds roll out of the lower-ladder range, the proceeds may be reinvested at the higher-yielding upper-ladder range, assuming a positively sloped yield curve. This has the potential effect of raising the yield of the portfolio. The result can be positive income and total return even in rapidly rising rate environments.

      This can be particularly helpful to investors who want to achieve an attractive total return regardless of the interest-rate environment, but want to avoid price and reinvestment risk. While there may be price fluctuations over time, matching maturities of the bonds to an investor's time horizon may help with the primary goal of capital preservation. In the event of price declines, investors can choose to allow the ladder to mature. This perspective allows an investor to maintain a long-term view and worry less about short-term price movements.

      Bottom line: Muni bonds have been in focus this tax season as investors see the impact of tax changes such as the SALT deduction cap. This is driving interest in state-specific muni strategies. Also, professionally managed ladders are one option for investors seeking tax-exempt income with some insulation from rising interest rates.