Do Tax Rates Affect Municipal
Bond Pricing?
Market Commentary
December 2016
IS THE PROSPECT OF TAX REFORM, with a lower maximum federal income tax rate,
responsible for the recent relative cheapening of municipal yields? The
10-year municipal-to-Treasury yield ratio increased from 94.7% to 105.8%
in November 2016, as municipal yields climbed from 1.51% to 2.52% and
Treasury yields jumped from 1.60% to 2.38%.1 Is the increase in the ratio
based on an expectation of lower tax rates? Possibly, but the maximum tax
rate has not historically had a perceptible, consistent effect on the pricing of
tax-exempt bonds relative to Treasuries.
The Federal Reserve provides a convenient, publicly-available source of data for this
analysis, based on historical information on the yields of constant maturity Treasury
securities and the Bond Buyer 20 Index of general obligation bonds maturing in 20
years. The chart below shows the ratio between the Bond Buyer 20 Index and 10-year
and 30-year Treasury yields from 1982 through 2001, a period when the maximum tax
rate changed several times. (The U.S. Treasury stopped issuing 30-year bonds in 2002
and resumed issuance in 2006.) Ratios have been quite volatile during the period under
consideration, spiking during the debate over the Tax Reform Act of 1986 and shortly
after the Act lowered the top tax rate. Ratios eventually settled back down to levels
consistent with where they had been before tax rates were lowered.
Cadmus Hicks, CFA, PhD
Manager of Performance and Risk Analysis
Market Strategist
Nuveen Asset Management, LLC
Municipal-to-Treasury Ratios Have Been Volatile
Bond Buyer 20 Index/30-Year U.S. Treasury Yield Ratio
Bond Buyer 20 Index/10-Year U.S. Treasury Yield Ratio
Leading the Way in Municipal Bonds
Top Federal Tax Rate
110%
50%
100%
45%
90%
40%
80%
35%
70%
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
30%
Yield Ratio
55%
Top Federal Tax Rate
120%
Data source: Federal Reserve, 1/1/82 – 12/31/01.
1Data source: Bloomberg L.P., Thomson Reuters. According to the Thomson Reuters scale of yields of general obligation bonds
rated AAA. Past performance is no guarantee of future results. Indices are unmanaged and unavailable for direct investment.
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This municipal bond heritage is reflected in
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portfolios today.*
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* Nuveen Investments, Inc. traces its history back to 1898.
Nuveen’s asset management business was established in
1989. Nuveen Asset Management credit research analysts
and municipal fixed income assets under management
as of 9/30/16.
Do Tax Rates Affect Municipal Bond Pricing?
December 2016
The table below shows how the average ratio of tax-exempt to
taxable yields has varied under different tax regimes.
2016, the average ratio of 5-year AAA rated, general obligation
municipal yields to 5-year Treasury yields was 87%, while the
10-year ratio was 93%, and the 30-year ratio was 103%. It is
not likely that the tax bracket of the marginal investor varies by
maturity, so a different factor must be involved.
Ratios Vary Based on the Maximum Tax Rate
Bond Buyer 20 / Treasury Ratios
Period
Maximum Tax Rate
BB20 / 10-Year
BB20 / 30-Year
1982-86
50.0%
87.7%
87.4%
1987
38.5%
91.0%
89.0%
1988-90
33.0%
85.7%
85.3%
1991-92
31.0%
90.2%
84.5%
1993-2001
39.6%
93.5%
88.8%
In our view, a more likely explanation is that tax-exempt bonds
do not compete with fully taxable bonds but with taxable bonds
purchased for tax-deferred accounts such as pension plans,
insurance policies and individual retirement accounts. This
model better explains the upwardly sloping ratio curve of taxexempt to taxable yields, since a longer time horizon provides a
greater benefit from deferring taxes.
Data source: Maximum Tax Rate, Walters Kluwer, CCH, http://www.cch.com/
WBOT2013/029IncomeTaxRates.asp. Past performance is no guarantee of future results.
Indices are unmanaged and unavailable for direct investment.
As a result of the Tax Reform Act of 1986, the maximum federal
tax rate fell from 50% to 38.5% in the transition year of 1987,
and then down to 33% for the next two years. The initial drop
in the tax rate was accompanied by an increase in the ratios in
1987, which is what one would expect if the maximum tax rate
affected the pricing of tax-free securities.
In this model, the effective tax rate is determined, not by the
amount of taxes one would pay on interest income in the current
year, but by the present value of taxes to be paid many years in
the future. The effect of a decline in the current tax rate is muted
by the fact that the effective tax rate is already lower by virtue of
the deferral. Hence, the effective tax rate does not fall as much as
the current tax rate (see Technical Note at the end of this report).
In other words, a drop in the tax rate lowers both the value of
tax-exemption and the value of tax-deferral.
However, when the tax rate fell to 33%, the average ratios
declined to levels lower than when the top tax rate was 50%.
The slight reduction in the tax rate in 1991 and 1992 was
associated with an increase in the ratio versus 10-year Treasuries,
but a modest decrease in the ratio to 30-year Treasuries. The
difference between the 10-year and 30-year ratios resulted
from a steepening of the yield curve as the fed funds rate was
lowered from an average of 6.91% in January 1991 to 2.92% in
December 1992. Finally, when the tax rate jumped to 39.6% in
1993, municipal-to-Treasury ratios also rose, instead of falling as
one might expect.
Another consideration for tax-deferred investments is that the
tax rate may be higher in later years within the investor’s time
horizon and, more importantly, when earnings are taxed upon
withdrawal from the accounts. Therefore, a reduction in the
current tax rate may not have much effect on how investors value
tax-exemption relative to tax-deferral.
From the perspective of those who want to preserve tax-exempt
bonds as an efficient mechanism for financing our nation’s
most critical infrastructure, lowering the top marginal tax rate
reduces the federal government’s incentive to limit the benefits
of exclusions and deductions to what they would be for someone
in the 28% tax bracket. This provision, which has been included
in the last few budgets proposed by the Obama administration,
would effectively levy an 11.9% tax on tax-exempt bonds held by
someone in the 39.6% bracket. In our model, the effect of such
a 28% limitation on the relative value of municipal bonds would
be much greater than the effect of lowering the maximum rate
to 28%. The limitation would not affect the value of tax-deferral,
but would reduce the value of tax-exemption.
Correlation is Low Between Tax Rates
and Ratios
Why is there so little correlation between the highest marginal
federal tax rate and the ratio between tax-exempt and taxable
securities? Some have surmised that the marginal investor in
tax-exempt bonds (i.e., the person who buys tax-exempt bonds
but gets the least tax benefit from the tax exemption) is in a
tax bracket lower than that of the top marginal rate, and thus
the yield this investor requires to purchase a tax-exempt rather
than a taxable bond is not much affected by such changes in the
maximum tax rate.
However, that model fails to account for the fact that the ratios
of tax-exempt to taxable yields are usually higher in the longer
maturities. For example, during the 10 years ending September
Regardless of one’s theory about the factors that affect how
tax-exempt bonds are priced relative to taxable securities, the
2
Do Tax Rates Affect Municipal Bond Pricing?
December 2016
historical record indicates it is not safe to assume that a lower top marginal tax rate will
lead to higher ratios of tax-exempt to taxable yields.
Technical Note
To illustrate how tax-deferral mitigates the benefit of a reduction in the tax rate, consider
an investment of $100,000 that produces $4,000 of interest income each year. If that
income is taxed at 35% in the year earned, the taxpayer will pay $1,400 to the federal
government. If that income is not taxed until 20 years later, the present value of that tax
liability will be $639 (assuming a 4% discount rate compounded annually). The result is
an effective tax rate of 15.97% (639 / 4,000 = 0.1597).
On the other hand, if the tax rate is 28%, the tax liability of $1,120 would have a present
value of $511. This implies an effective tax rate of 12.78%, which is only 3.19 percentage
points lower than the effective tax rate produced by a 35% nominal tax rate even though
the nominal tax rate has been reduced by 7 percentage points.
If the tax rate reverts to 35% when the earnings are withdrawn from the account, the
effective tax rate would again be 15.97%. ▪
For more information, please consult with your financial advisor and visit nuveen.com.
SOURCES
RISKS AND OTHER IMPORTANT CONSIDERATIONS
This information represents the opinion of Nuveen Asset Management, LLC and is not
intended to be a forecast of future events and this is no guarantee of any future result. It is not
intended to provide specific advice and should not be considered investment advice of any
kind. Information was obtained from third party sources which we believe to be reliable but are
not guaranteed as to their accuracy or completeness. This report contains no recommendations
to buy or sell specific securities or investment products. All investments carry a certain degree
of risk, including possible loss principal and there is no assurance that an investment will
provide positive performance over any period of time. It is important to review your investment
objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
Debt or fixed income securities are subject to credit risk and interest rate risk. The value of and
income generated by debt securities will decrease or increase based on changes in market
interest rates. As interest rates rise, bond prices fall. Credit risk refers to an issuer’s ability to
make interest and principal payments when due. Reinvestment risk is the risk that income
from a portfolio will decline if and when the portfolio invests the proceeds from matured,
traded or called bonds at market interest rates that are below the portfolio’s current earnings
rate.
Clients should contact their tax advisor regarding the suitability of tax-exempt investments in
their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on
the level of interest rates, market conditions and the credit quality of the issuer. Income may be
subject to the alternative minimum tax (AMT), and in some cases other federal income taxes,
and/or state and local taxes, based on state of residence. Income from municipal bonds held
by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse
interpretations by the Internal Revenue Service or state authorities, or noncompliant conduct
of a bond issuer.
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GPE-TAXRMN-1216P 21422-INV-AN-12/17
Federal Reserve Board Interest Rates
https://www.federalreserve.gov/datadownload/Choose.aspx?rel=H15
The Federal Reserve recently stopped maintaining its series of the Bond Buyer 20 Index on their website.
In the future, a subscription to The Bond Buyer will be required to obtain this information.
MMD Municipal Yield Curves
Thomson Reuters (Subscription required)