Doing so, they subsidize government, which is, well, sort of like a tax
Avoiding, deferring or minimizing taxes is a central selling point aimed at individual investors. It’s the carrot held out to get us to save in a workplace retirement plan or individual retirement account. Same goes for 529 plans that help families save for college. The immense growth in exchange-traded funds over the past 15 years is built on the fact that they are more tax efficient than actively managed mutual funds.
And then there’s the $4 trillion municipal bond market in which households account for about two-thirds of investors. It’s singular marketing pitch: tax-free interest income.
Based on a deconstruction of pricing of state-issued municipal bonds, University of Delaware’s Matthias Fleckenstein and UCLA Anderson’s Francis A. Longstaff find that investors pay a premium for that tax-exempt income.
Much like investors who accept the lower yields of Treasury bonds as the trade-off for unparalleled credit safety and liquidity — a phenomenon known as the convenience yield — they assert there is also a convenience premium at work with municipal bonds.
In a perfectly priced world, of course, a muni bond would pay interest precisely equivalent to a Treasury bond minus the investor’s tax burden on the Treasury (and also adjusted for liquidity and credit quality of the issuing state or municipality). But munis pay investors a bit less than all that, suggesting investors overvalue the pleasure of not being taxed.
Fleckenstein and Longstaff find that between April 2008 and December 2021 state-issued municipal bonds across 21 states on average had a yield that was nearly 15 basis points lower than can be explained by fundamental valuation. As shown in the chart below, the size of this convenience premium varies by state, though investors in bonds from each state indeed pay a price.
In the bond world where yield and price are inextricably related — when one rises the other falls — this lower yield effectively means investors accept a higher price to own municipal bonds. This is the “convenience premium” the researchers refer to.
And that average 15 basis point yield concession is significant given that the average municipal bond yield during this period of interest rate suppression by the Federal Reserve was around 1.5% across the data set.
After establishing the existence of their municipal bond convenience premium, Fleckenstein and Longstaff ran a series of analytical forays to explore what may compel investors to settle for this trade-off. While Treasury investors accept a lower yield for the convenience of rock solid credit and impeccable liquidity, the researchers suggest that for municipal bonds the motivation seems to be that “investors are willing to pay a substantial premium to avoid taxes.”
Which leads to an interesting dynamic: The state seems to extract a fiscal benefit (lower interest due to investors) from the very resident who is focused on avoiding forking over more money to state tax coffers.
Investing Focus: Minimize Tax
Interest income earned on the vast majority of municipal bonds is exempt from federal tax. In states that levy tax on income, bonds issued by a state or local municipality are also exempt from tax. And that can be a significant investment win. The current top federal income tax rate is 37%; high income households are also in the crosshairs of an additional 3.8% net investment income tax. For high income households in states with steep tax rates (California, New York and New Jersey), the combined federal-state income tax rate is more than 50%.
The heavy presence of individual investors in the municipal market gave Fleckenstein and Longstaff a valuable real-world data set to explore the role tax aversion may play in the pricing of this asset class.
They started by isolating the price of credit risk and liquidity risk for their pool of municipal bonds, as both factors play a substantial role in determining a bond’s yield.
They were able to isolate credit risk by focusing on state-issued general obligation bonds (ignoring local issues) in the 21 states where there was ample data on credit default swap spreads for those states. A CDS spread is the fee paid by one party (the state, here) to a third party who agrees to step in and make payments if there’s a default. In academic circles, the CDS spread is considered a standard shortcut to estimate the credit risk of a bond. Subtracting the cost of a state’s spread from a municipal bond’s gross bond yield takes the credit risk out of the equation.
To isolate the liquidity premium embedded in municipal bonds, Fleckenstein and Longstaff leverage an oddity: A small slice of this market — private placement bonds — is in fact taxable at the federal level. Though, they typically remain tax exempt for state tax returns. That’s exactly how Treasury bonds are taxed, which gave the researchers a mechanism to estimate the liquidity premium of a municipal bond by comparing the credit-adjusted yield of a taxable municipal bond to the yield of a comparable maturity term Treasury.
The 1.52% average yield across the more than 600,000 bond prices observations in their analysis is reduced to a net yield of less than 0.60% after adjusting for credit and liquidity risk.
With credit and liquidity risk stripped from a bond’s yield, it stands to reason that the net yield from similar bonds from different states should be equal.
But they aren’t. Investors in states with higher tax burdens paid a consistently higher premium, supporting the theory that the convenience premium is driven by investors’ focus on tax avoidance.
An analysis estimates that a state with a maximum marginal tax rate of 10% had a net yield that was 5 basis points lower than the net yield from a bond in a state with no income tax. For someone with a combined federal-state tax rate of 40%, the researchers estimate the convenience premium might be around 20 basis points.
Isolating Tax Avoidance as a Motivation
Fleckenstein and Longstaff then turn to an interesting mix of explorations to get at the why of the municipal bond convenience premium.
Prior research has established a model for studying the impact of economic policy uncertainty on investor behavior. Fleckenstein and Longstaff leverage that research and find that the average convenience premium rose in months when there was a heightened possibility of public policy creating more tax burden.
They also discovered that as the convenience premium rose for a given state, so too did the subsequent inflows into mutual funds that invest solely in municipal bonds from that state. In the same vein, when they pored over 1040 federal tax return data they found that there was more tax-reduction in play (contributing to an IRA or workplace retirement plan, itemizing deductions, making charitable contributions), the higher a state’s municipal bond convenience premium.
The 2017 upheaval that limited the federal deduction for state and local taxes, or SALT, to $10,000 provided a real-world shock to analyze. Here too, in states where the SALT change was more painful for investors, the municipal bond convenience premium rose.
They even took a look at interstate migration patterns in their 21 states and found a “significant positive relationship” between folks who moved from a state with a high convenience premium into one of the seven states without an income tax.
“These results all provide strong evidence that the convenience premia incorporated in the prices of tax-exempt municipal bonds are driven by investor concerns about taxation,” they conclude.
Distinguished Professor of Finance, Allstate Chair in Insurance and Finance, Area Chair
About the Research
Fleckenstein, M., Longstaff, F.A. (2023). Do Municipal Bond Investors Pay a Convenience Premium to Avoid Taxes?