The election may mean revisiting your portfolio’s tax advantagesBallot initiatives in key Western states may alter taxable-equivalent yields

The presidential election is grabbing the majority of headlines this election season. But in many states, interesting local propositions will be on the ballot, as local governments seek new funding to shore up essential public services. Below, we note upcoming ballot initiatives in two states that tend to be major municipal bond issuers: Colorado and California. We briefly explore how, if passed, such propositions could potentially shift the landscape for municipal bond investors who live in those states.

Competition for resources

Municipal finance often involves a tug of war to ultimately determine the allocation of scarce financial resources. State officials are often challenged to find a balance between the needs of constituents and the constraints imposed by budget limitations. Sometimes, current funding levels are insufficient to support a municipality’s operations for the longer term, bringing about ballot initiatives that allow voters to decide if funding should be expanded via the introduction of higher taxes.

Such ballot initiatives naturally spark public debate about their projected economic effects. And initiatives that represent substantial changes in public policy only tend to amplify the discussion. If passed, state-level initiatives that result in higher taxes could create a subsequent question for municipal bond investors who live in those states: Does the new tax level make an allocation to tax-advantaged investments appear more favorable?

Initiative in Colorado

Colorado’s Amendment 69,1 currently slated for the Nov. 8 ballot, would make Colorado the first state to opt out of the Affordable Care Act and replace it with its own plan, delivering medical care that is free to all residents. The measure relies on state tax increases to fund the program, and the amount of money required is significant. At $25 billion, the proposed tax bill is larger than last year’s entire state budget.

We think the initiative is monumental for a number of reasons, given the politics surrounding debates about healthcare as well as tax policy in general. Putting the politics of the measure aside, we’ve looked at the potential for Amendment 69 to generally change the calculus on tax-advantaged investing for Colorado-based investors. If large tax initiatives like Colorado’s do pass, then it may be a good time for investors facing larger tax bills to discuss tax-advantaged investments with an advisor, and consider whether municipal bonds make sense — either as a first-time investment, or as an increase to an existing allocation.

Understanding the importance of taxable-equivalent yield

The unique feature of municipal bonds is that they allow for investment income to be treated on a tax-free basis. The concept of taxable-equivalent yield (TEY) helps illustrate this: Essentially, TEY is the yield that a taxable bond would have to generate in order to match the tax-advantaged yields generated by municipal issues.

View chart
Taxable equivalent yield: Making a difference

Taxable-equivalent yield: Making a difference

Consider, for instance, yields on municipal bonds versus yields generated by other types of bonds. (For this example, we’ll compare municipals against corporate and Treasury bonds, given their status as familiar, core asset classes.) As the chart below shows, even though municipal bonds generally deliver yields that are below those generated by corporate and Treasury bonds, municipal yields have an edge when they are adjusted for the effects of income taxes.

Taxable-equivalent yield: Making a difference

Close chart

Data: Barclays as of Aug. 18, 2016.

Chart shown is for comparison purpose only.

As rates go, so do the benefits of TEY

When the basic math of TEY is applied to state-level ballot initiatives, the tax advantage becomes even more pronounced. The enactment of new state taxes could likely result in an additional dose of taxable-equivalent yield for municipal debt.

California's busy proposition pipeline

At this writing, no fewer than 17 propositions have been approved to appear on the November ballot in California, which is well known for the use of public ballot initiatives. If several measures manage to pass, resulting in higher net state taxes, investors may want to consult with their advisors regarding the in-state tax advantages for municipal investments. With so many initiatives in play, it will take a careful extra step to calculate the net effect on California state taxes, but we think that net effect will be important for residents to understand. Again, residents who hold California-issued municipal bonds will not have to pay federal, state, or local taxes on the income generated by those municipal securities.2

Of the ballot initiatives that will be in play this November, no one can predict which will pass, but the consequences could be meaningful for tax-sensitive investors.

The takeaway: In general, tax-free income becomes more attractive as tax rates increase. If higher taxes become a reality where you live, the interest paid by municipal bonds could provide a way to generate income that is exempt from federal, state, and local taxes.

1Formally known as the Colorado State Health Care System Initiative

2Depending on each investor’s circumstances, it’s possible that some portion of income may be subject to the federal alternative minimum tax (AMT). As always, investors should be aware that capital gains on municipal bond sales are taxable.

The views expressed represent the Manager's assessment of the market environment as of August 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

This information is not intended to be legal or tax advice. Please consult your tax advisor for assistance.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.


Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. The Funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Funds may be prepaid prior to maturity, potentially forcing the Funds to reinvest that money at a lower interest rate.

Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to state or local and/or the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable.

Funds that invest primarily in one state may be more susceptible to the economic, regulatory, regional, and other factors of that state than geographically diversified funds.

This document may mention bond ratings published by Standard & Poor’s, a nationally recognized statistical rating organization. Bonds rated AAA are rated as having the highest quality and are generally considered to have the lowest degree of investment risk.

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