[IMGCAP(1)]Municipal bonds typically represent an investor’s safest asset or the most conservative component of the overall investment portfolio.
As such, the yield—or expected return on this asset category—is fairly modest in nominal terms, but offers safety of principal and tax-free income, and generally there is some premium over inflation and money market rates of return.
Professional asset managers strive to add excess return to tax-free fixed income portfolios without sacrificing their standards for quality or duration.
However, few are taking advantage of one of the largest pricing inefficiencies in the high-grade fixed income capital markets. Municipal bonds subject to the Alternative Minimum Tax are consistently undervalued and offer considerable value for certain high income investors. Those who are capable of capitalizing on this fixed income investment vehicle have an opportunity to earn substantially higher yields on their municipal bond investments. Crawford Investment Counsel has been exploiting this inefficiency for the benefit of its clients who fall into the upper tax brackets.
The simple reason why AMT-subject issues are so attractive is because relatively few bond buyers truly understand them. This leads to lower demand, which in the bond market typically translates to additional yield. In short, the inefficiency exists because the vast majority of buyers of municipal bonds avoid issuers that are subject to the alternative minimum tax out of fear that they (or their clients) will be subject to a 28 percent tax rate on what is otherwise a tax-exempt bond.
While paying tax on a tax-exempt issue is typically not desirable, in many cases the excess yield offered by AMT-subject municipals leads to a superior after-tax yield, even for those investors who do fall into the AMT bracket. However, the real opportunity is for those higher income earners paying marginal tax rates well above the 28 percent AMT rate.
AMT-subject municipals came into existence in 1986. They are also sometimes referred to as “private activity” bonds. The AMT status is derived from the underlying project that is being financed. For example, if a municipal bond is issued for the purpose of financing an airport or a port improvement, more than likely it will be issued as a private activity bond and the interest paid to bondholders will be subject to the AMT, if the bondholder is subject to the tax.
It is not the source of the bond guarantor that determines the AMT status, it is the underlying project. For example, if the Port of Houston, Texas, issues debt for port improvements, it is AMT subject, even though the debt is guaranteed by Harris County, Texas, and is AAA rated.
Over the past 10 years, there has been a substantial increase in the relative value of Alternative Minimum Tax-subject municipals. As more American taxpayers become subject to the tax, many avoid AMT-subject bonds, leading to a favorable price and yield differential for those who have an ability to earn AMT-subject income. This investment is well-suited for the individual who has high amounts of ordinary income and is unlikely to be subject to the AMT tax.
The relative attractiveness of AMT-subject municipals has been growing. The increase in yield has also coincided with a drop in overall interest rates, adding to the relative attractiveness of the relationship. We feel this pickup in yield is significant given today’s low interest rate environment. In the current environment for high-quality municipal bonds, the increase in yield can be as much as 25 to 100 basis points.
One additional advantage is a possibility for future comprehensive tax reform that eliminates the AMT tax altogether. This could lead to an increase in the value of our investment as the AMT stigma is removed. We would expect the bonds to increase in price as the yield drops to the level of non-AMT subject bonds of the same maturity and quality. Importantly, an AMT-subject bond will not enjoy the same amount of liquidity as a non-AMT bond. However, we find most investors of short-to-intermediate maturity bonds typically hold them to maturity. Thus, the minor lack of liquidity is negated as bonds edge closer to maturity each year. We would also caution the unsophisticated investor from employing this strategy without the assistance of a professional bond manager with expertise in the AMT sector due to the trading nuances of this type of municipal bond.
An individual’s AMT status depends on many factors. A tax advisor or CPA has the ability through their high net worth clients’ tax plans to identify which high earners have a potential “AMT appetite,” and could earn superior tax-free investment returns as a result. For those with a substantial appetite for AMT-sensitive income, this yield-enhancement strategy may be appropriate.
Jonathan R. Morgan is managing director of fixed income investments at Crawford Investment Counsel, Inc., an Atlanta-based firm that specializes in the municipal investment market for both individual and institutional clients.
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