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SALT in the wounds supports record muni inflows

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      By Nisha Patel, CFA, Portfolio Manager, Eaton Vance Management

      New York - The focus in the muni market turns now to taxes, with many high tax bracket investors feeling the impact of the state and local tax (SALT) deduction cap. This has helped promote record inflows into the muni market as these investors seek tax havens. The strong inflows could continue well past tax season, as the memory of higher state and local tax bills continues to sting investors.

      According to Lipper, municipal mutual funds have experienced record inflows of over $22 billion in the first three months of 2019; the best start to a year from a flows perspective since Lipper began gathering the data in 1992. A major cause of this strong demand was due the $10,000 cap on the SALT deduction, which was passed in The Tax Cuts and Jobs Act of 2017.

      The SALT cap effectively raised investors' state tax rate, causing many investors in high-tax states to buy muni bonds by issuers from their own state in an effort to lower their tax burden. The effect of this demand has been particularly felt in high tax states such as California, New Jersey and New York where the state tax rate is 13.3%, 10.75%, and 8.82%, respectively, for the highest tax brackets.

      The ability to invest in these high tax states has become increasingly important to investors. However, it should be noted that due to the heavy flows seen in some of these states, it is important to evaluate various options to truly assess if an in-state bond is offering more yield versus an out-of-state bond. Let's take a look at three muni-bond examples in the 5-year maturity bucket (see the figure below) to determine the difference in yields for a California resident in the highest bracket.

      Blog Image TABS Muni April 11

      Bond 2 is yielding 23 bps more than Bond 1, primarily because of its lower credit rating. In addition, note that Bond 3 is an out of state bond and has the same AAA rating as Bond 1 but it yields 13 bps more after the state income tax than Bond 1.

      Bottom line: The impact of the SALT cap will continue to impact high tax bracket individuals in high tax states for the foreseeable future, and particularly during this year's tax season. As investors look to position their municipal bond portfolios accordingly, we would like to remind them to look into strategies that allow them to take advantage of investing in these high tax states, yet offer flexibility to be able to buy out-of-state bonds when they are attractive on an after tax basis.