MARKETS

Changes in Tax Laws

Drive More Americans
Into Municipal Bonds
Investors in high-tax states like New York and
California are piling into munis this year, fueled in part
by the 2017 tax overhaul that raised tax burdens for
some high-income households.

By Heather Gillers and Richard Rubin

Investors in high-tax states like New York and

California are piling into municipal bonds this year,
fueled in part by the 2017 tax overhaul that raised tax
burdens for some high-income households.

The purchases are driven by taxpayers’ desire to

generate tax-free income, and this year’s buying surge
started right as taxpayers were seeing the full impact of
the new law.

Mutual and exchange-traded funds containing

California, New York and New Jersey munis have

received a combined total of $6.5 billion in inflows this
year through the end of July. The inflows marked the
most of any seven-month period since at least 2014,
according to Lipper. People started completing the first
tax returns under the new law in late January and
February.
The purchases add to the already-high demand for
municipal bonds, pushing up bond prices further and
diminishing the benefit taxpayers are seeking. But they
also make it easier and cheaper for governments to
borrow.

“High-income taxpayers oftentimes were a little bit

taken aback by the fact that their tax bills either stayed
pretty flat or maybe their aggregate tax bill increased.
And that always raises a question of: What can I do
about this?” said Suzanne Shier, chief tax strategist for
wealth management at Northern Trust Corp.

The vast majority of taxpayers got federal tax cuts

under the law, but 12% of those with incomes over $1
million got tax increases.

That’s partly because the new law capped at $10,000

the amount of state and local tax bills Americans could
deduct from their federal taxable income. This hit the
wallets of some high earners in high-tax states
and layered the full burden of state and local income
taxes atop federal taxes.

Affluent taxpayers are generally the ones most able to

reshape their investments to save on taxes. In some
cases, they now face higher marginal combined
income-tax rates than they did under the old law,
giving them a larger tax incentive to invest in municipal
bonds. Munis throw off interest that is free from federal
taxes and generally from state taxes in the state where
the bond was issued.

Advisers said sophisticated taxpayers moved quickly

after the new law took effect, and taxpayers who
bought munis in the immediate aftermath of the law
generally got a bigger advantage than this year’s
second wave of buyers. Since the end of 2017, municipal
bonds have produced returns of 2.3% nationwide and
2.5% for California bonds, according to Bloomberg
Barclays.

As prices rose, driving down the income investors

could earn from munis, the benefit to taxpayers seeking
to cut their tax bills diminished.

“The spoils go to the early birds in this sort of thing,”

said Tim Steffen, director of advanced planning at
Robert W. Baird & Co. in Milwaukee.

Nicholos Venditti, who manages a portfolio of $500

million in tax-exempt California bonds for New
Mexico-based Thornburg Investment Management,
said recently he has counseled California clients eager
to invest that they may be better off in Treasurys or
municipal debt from other states.

“I want all the money I can get,” Mr. Venditti said.

“But right now, today, there are not a lot of great
options in the California market for me to invest
in.”The demand for municipal debt issued in high-tax
states has lowered borrowing costs for governments. In
a deal priced last week, San Francisco’s Bay Area
Rapid Transit, or BART, system will pay a yield of 1%
on a six-year bond. The benchmark rate for a muni
bond with a similar maturity date and creditworthiness
was 1.19%, according to Thomson Reuters.

Also pushing up municipal-bond prices over the past

several months: expectations of a Federal Reserve
interest-rate cut enacted last week, an appetite for
fixed-income investments amid a 10-year bull market
in stocks and a drop in supply that is another result of
the 2017 tax overhaul. Congress ended the tax
exemption for bonds refinanced before the refinancing
date agreed upon in the bond agreement, driving down
new issuance. Also, governments anxious about what
Congress would do rushed to issue bonds in late 2017
before the bill passed, leading to a lull over the past
year.

To get higher yields that are tax-free in California,

some investors are pushing deeper into riskier
municipal debt such as bonds issued for charter
schools, nursing homes and real-estate development
projects. Governments confer their tax-exempt
borrowing power on those entities because they are
seen to spur economic development or have some other
public benefit.

“When we bring a high-yield bond issue to market,

we receive a lot of demand from a broad swath of
buyers,” said Sara Brown, head of the California
general government group at Stifel, a municipal-bond
underwriter.

Advisers cautioned that investors sometimes get too

enamored of the tax savings from buying in-state
bonds and ignore some of the downsides. Those
include lower yields than corporate debt and the
danger of concentrating too much risk in one state.
That is a particular concern for investors in New Jersey,
where burdensome pension obligations have pushed
the state credit rating to among the lowest of any state.

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Write to Heather Gillers at heather.gillers@wsj.com

and Richard Rubin at richard.rubin@wsj.com