Why we’ve seen a solid run in the municipal bonds market

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It’s been a solid run for municipal bonds so far in 2014. And that has many investors wondering what to do next. Peter Hayes prescribes a three-step muni workout.

The municipal market has been on a tear this year. And I’ll be the first to admit — we didn’t necessarily expect it. In fact, few people anticipated interest rates would fall (and bond prices rise) as they have in the first seven months of the year. Munis also benefited from an imbalance in supply and demand, which helped support pricing, and from a collective “ouch” from taxpayers when they saw their 2013 tax bills. Tax-exempt munis looked that much better.

income tax collections

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Market Realist – Tax payments have been steadily increasing over the years, as you can see in the graph above. The rate of tax chargeable on dividends and capital gains increased from 15% to 20% in 2013. The death tax too saw an increase (on estates larger than $5 million) from 35% to 40% in 2014. In 2013, the marginal tax rate for individual taxable incomes above $400,000 rose from 35% to 39.6%.

tax exempt muni bond

Market Realist – In the current context of rising taxes, tax-free muni bonds (MUB) hold a unique tax advantage over U.S. Treasuries (TLT)(IEF) , investment-grade corporate bonds (LQD), high yield corporate bonds (HYG), and junk bonds (JNK). Tax free muni-bonds can be extremely helpful for investors in the higher income tax brackets.

As you can see in the above graph, the yields from a 4.5% tax-free muni bond would be higher than the post-tax yield on a 6% taxable bond for the 33% marginal tax rate bracket. That said, yields on muni bonds are much lower than that of corporate bonds, given the lower risk.

Read on to the next part of this series to learn the strategy investors can follow to protect their gains.

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