Tax-free bonds

LEGG MASON FLASH

Bracket creep

and muni market

Investors may disagree on whether the federal government’s massive stimulus spending is genius or madness, but one thing’s clear to everyone: the bill will be huge and higher taxes are a real possibility. Proposals have already been voiced in Washington that would raise the tax burden on the wealthy, and top earners could soon be handing over more of their income to Uncle Sam.

If there’s any silver lining here, it's the instantaneous improvement in tax-equivalent yield (TEY) that muni bond investors will reap if they find themselves in a higher tax bracket — which could well be the case if the top bracket is extended beyond the current level of 35%. As the table below shows, the difference in TEY can be substantial from one bracket to another:

The municipal advantage
	Tax equivalent yields (%)
	Federal income tax bracket
Tax-exempt yields(%)	25%	28%	33%	35%	39.6%
3.00	4.00	4.17	4.48	4.62	4.97
3.50	4.67	4.86	5.22	5.38	5.79
4.00	5.33	5.56	5.97	6.15	6.62
4.50	6.00	6.25	6.72	6.92	7.45
5.00	6.67	6.94	7.46	7.69	8.28
5.50	7.33	7.64	8.21	8.46	9.11
6.00	8.00	8.33	8.96	9.23	9.93

Source: Legg Mason. The table above is hypothetical and for illustrative purposes only and is not reflective of how an actual investment performed. Please note that the analysis presented above does not account for state or local taxes, if applicable or any fees and expenses associated with investing. Clients should consult their tax advisor about their particular situation.

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Consider a taxable bond with a 3% coupon in today’s market. After taxes, that’s the equivalent of a 4.62% yield for an investor in today’s top current top bracket of 35%. — or, for a $100,000 investment, an after-tax advantage of $1,620. But if the previous top marginal rate of 39.6%[1] is reinstated, the TEY jumps to 4.97% — and the advantage rises by $350 to $1,970.

An increase in the potential tax benefits could also provide a tailwind for municipal bond values — prices of existing bonds could gain based on the heightened value to high-income investors and from rising demand as more Americans seek out tax-free investment income.

As the question about how to pay for increased spending heats up, it’s important to stay in front of legislation that could impact client assets. For perspectives on the bond market and products that can help you and your clients make the most of the municipal tax advantage, talk to your Legg Mason Sales Director.

Investment risks

All investments involve risk, including possible loss of principal. Fixed income investments are subject to interest rate and credit risks. As interest rates rise, bond prices fall, reducing the value of fixed income securities. There is also a risk that an issuer will be unable to make principal and/or interest payments. Certain investors may be subject to the federal Alternative Minimum Tax (AMT), and state and local taxes will apply. Capital gains, if any, are fully taxable. It depends on the individual tax situation. Legg Mason, Inc., its affiliates, and its employees are not in the business of providing tax or legal advice to taxpayers. These materials and any tax-related statements are not intended or written to be used or relied upon by any such taxpayer for the purpose of avoiding tax penalties. Tax-related statements, if any, may have been written in connection with the "promotion or marketing" of the transaction(s) or matter(s) addressed by these materials, to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.