How Do Lower Income Tax Rates Affect Municipal Bond Rates?

Municipal bonds are debt securities issued by states, cities, and other government entities to fund public projects like schools and highways. The interest paid to investors is often treated differently for tax purposes than interest from other investments. How changes in federal income tax rates can alter the attractiveness and interest rates of these bonds is an important consideration for investors.

The Tax Advantage of Municipal Bonds

The primary feature of most municipal bonds is their tax treatment. Interest income earned from these bonds is typically exempt from federal income tax. This means the U.S. government does not tax the earnings an investor receives from lending money to a state or local government.

This tax benefit can extend to state and local taxes. Generally, if investors purchase municipal bonds issued by their own state of residence, the interest income may also be exempt from that state’s income tax. This creates a dual tax advantage, making the bonds particularly appealing to residents of states with higher income tax rates.

This treatment contrasts with fully taxable bonds, such as those issued by corporations. Interest earned on corporate bonds is considered ordinary income and is taxed at the investor’s regular federal income tax rate, which can be as high as 37% depending on their income bracket.

Calculating Tax-Equivalent Yield

To compare a tax-exempt municipal bond to a taxable bond, investors use a calculation called the tax-equivalent yield (TEY). This calculation determines what yield a taxable bond would need to offer to provide the same after-tax return as a municipal bond. The formula is: Tax-Equivalent Yield = Municipal Bond Yield / (1 – Marginal Tax Rate). The marginal tax rate is the rate an investor pays on their next dollar of income.

Consider an investor in the 32% federal income tax bracket looking at a municipal bond with a 3% yield. Using the formula, the TEY would be 3% / (1 – 0.32), which equals approximately 4.41%. This means a corporate bond or other taxable investment would need to yield 4.41% to match the after-tax return of the 3% municipal bond for this particular investor.

Now, if another investor is in the 22% tax bracket, the same 3% municipal bond has a different relative value. For this person, the TEY is 3% / (1 – 0.22), or about 3.85%. The calculation demonstrates that the higher an investor’s marginal tax rate, the greater the benefit of the tax exemption.

The Market Impact of Lower Tax Rates

When federal income tax rates are lowered, the tax advantage of municipal bonds diminishes. The value of receiving tax-free interest is less pronounced when the tax rate an investor would otherwise have to pay is lower. This change directly impacts the tax-equivalent yield calculation.

Using the TEY formula, a reduction in the marginal tax rate lowers the resulting tax-equivalent yield. For example, for an investor whose tax rate drops from 32% to 24%, a 3% municipal bond’s TEY falls from 4.41% to 3.95%. The municipal bond is now equivalent to a taxable bond with a lower yield, making it less attractive relative to its taxable counterparts.

This reduced attractiveness leads to a decrease in demand for municipal bonds. With less demand, the market for these bonds must adjust to attract new capital. To compensate for the diminished tax advantage and stimulate demand, issuers of new municipal bonds are compelled to offer higher interest rates. By increasing the yield, they make the bonds more competitive against taxable investments in the new, lower-tax environment.

Considerations for Market Participants

For municipal issuers, such as cities and school districts, the need to offer higher interest rates translates directly into an increased cost of borrowing. This means that financing public works projects becomes more expensive, potentially straining budgets or delaying initiatives.

For individuals who already own existing municipal bonds, a rise in interest rates on newly issued bonds can have a negative impact. The market value of their older bonds, which carry a lower fixed interest rate, may decrease. This is because investors would prefer to buy the new bonds offering a higher return, making the existing, lower-yielding bonds less desirable in the secondary market.