In the category of timely topics, you can’t get much that’s fresher than this: in our spotlight this month we’ve got municipal bonds, the alternative minimum tax, tax reform, tax-free income, and three exceptional portfolio managers–all in one feature. Municipal bonds are of the moment because of subjects your clients are likely to be discussing right now: rebuilding communities in the wake of Hurricane Katrina, and taxes or tax reform–a timeless topic, but timely as well. A Congressional Ways and Means subcommittee hearing on tax reform that was originally scheduled for September 20th was postponed indefinitely while Congress works on Hurricane Katerina issues. One of the items on the agenda was the alternative minimum tax (AMT). An interview with those three managers is timely in another way: it introduces a special section on year-end tax planning just as we enter the fourth quarter.
Taxes and “munis” are linked in a number of interesting ways. State and local taxes pay the interest on bonds that are general obligations (GO bonds) of states and local municipalities. Revenue bonds–issued to finance projects that benefit the public, such as housing and hospitals; ports and airports; pollution control systems and stadiums–are secured by the revenues that those projects generate. Chances are that municipal bonds will be issued–some with private insurance backing them; some may have federal backing–to help rebuild parts of Louisiana, Mississippi, and Alabama.
Municipalities that issue muni bonds have the power to raise taxes in order to pay off the bonds, and because of that, investment- grade GO munis are considered extremely safe investments, second only to Treasury bonds in their ability to make good on their promise to pay. That doesn’t mean that their value doesn’t fluctuate day to day–of course it does in lockstep with interest rates–but clients can expect to receive timely payments of interest and principal if the bonds are held to maturity. Because of their safety and because the interest earned by investors is tax exempt, localities that issue munis save taxpayers billions of dollars in state and local taxes, because the rates munis pay are lower than interest rates paid on taxable bonds. When advisors’ clients buy munis issued in the state where they live, the interest clients earn is free from federal, state, and local taxes. But wait, is it really tax free? What if your client is one of the millions of Americans who are, or are about to be, subject to the AMT? Income from some munis is subject to the AMT, so it is important to know whether the munis your clients buy really are exempt from AMT, or are subject to the tax.
A Brief History of the AMT
The AMT was enacted in 1969 after it was discovered that because of loopholes in then-existing tax laws, 155 wealthy persons paid no federal income tax in 1967, even though their adjusted gross income (AGI) was above $200,000 (about $1.1 million in 2001 dollars), according to a 2001 Congressional Joint Economic Committee Study entitled The Alternative Minimum Tax for Individuals: A Growing Burden. By 1975, 20,000 individuals paid taxes under the AMT, and National Taxpayer Advocate Nina Olson estimated last year in testimony to Congress that by 2010, 30 million American taxpayers will be subject to the AMT (for further insight into the alternative minimum tax and how to address it, see Part III of our special year-end tax planning report on page 72 of the October issue).
So how do you know which munis are subject to the AMT? That’s where Christine Thompson, portfolio manager for the $345 million no-load Fidelity Tax-Free Bond Fund (FTABX), can help. The fund invests primarily in munis that are not subject to the AMT. “The Tax-Free Bond Fund is the newest fund [April 2001] we’ve added to Fidelity’s municipal bond group of products, because there was the observation that the alternative minimum tax (AMT) was expanding to include more people and the inclusion of bonds that may not be excluded from the AMT could grow to be a problem,” says Thompson.
According to Standard & Poor’s, the fund had three-year annualized returns of 5.75% versus 3.31% for the Lehman Brothers 5 Year Municipal Bond Index. The fund was renamed in August; it had been called the Spartan Tax-Free Bond Fund.
Standard & Poor’s ranks the fund four stars overall, while Morningstar gives five stars. Morningstar said recently it “could be the Holy Grail of bond funds,” and named Fidelity’s municipal bond fund team “Fixed-Income Manager of the Year for 2003.”
That team is led by Thompson and colleagues Doug McGinley, portfolio manager of the Fidelity Intermediate Municipal Income Fund, and Mark Sommer, portfolio manager of the Fidelity Short-Intermediate Municipal Income Fund, at Fidelity Research & Management in Merrimack, New Hampshire.
Do you three manage any funds together? CT: Actually, we have distinct responsibility for separate funds. Our municipal fund line-up includes five national funds: Mark manages the Fidelity Short-Intermediate Municipal Income Fund; Doug manages the Fidelity Intermediate Municipal Income Fund; and I manage the Fidelity Municipal Income Fund, Fidelity Tax-Free Bond Fund, and a fund for advisors, Fidelity Advisor Municipal Income Fund. In addition, we have 12 state funds and we all share responsibility for different funds there.
MS: We specifically have taken our Fidelity municipal product line and divided it up so that we all have involvement in a national market, and a different emphasis across the yield curve, as well as all have responsibility for single-state funds.
We have divided the market up in such a way that there is a certain amount of specialized focus, and with that focus we can help each other. We have overlap in the states that we cover; we have overlap in various parts of the yield curve.
What about the AMT aspect of the Tax-Free Bond Fund? CT: We can talk about AMT–where is it going, what are they going to do with tax reform–that’s all pending and a lot of that’s uncertain. Clearly there will be a large portion of the population that will become subject to the AMT if reform measures aren’t taken, and this was a fund that was introduced in order to provide an investment option for people who didn’t want to include AMT securities. What I emphasize when I talk about AMT even in our other 16 funds, is that it’s not a dominant strategy, because we invest with a goal of providing strong total returns, and not yield for its own sake. We only invest in things subject to the AMT to the extent we think they are going to offer a return advantage to other securities. If you look at the percentage of AMT bonds in our other funds it ranges, I’d say, over the past five years, somewhere between maybe 5% and 15%, so it’s not a large portion of the income of any of those portfolios. I’d encourage investors not to disregard funds that have a small [AMT-subject] component because [there may be] valuation-driven opportunities in that sector of the market that are compelling enough that you would accept a small portion.
Can you tell us about your investment process? CT: Fidelity’s approach is to invest in resources that help us employ valuation-based strategies to generate competitive, consistent returns for our shareholders. To do that we emphasize a number of research strategies that are tied to fundamental research, and work done by our credit research department, as well as strategies and tools that are quantitatively based and enable us to model individual securities, compare the characteristics of those securities, and understand on an aggregated basis how our funds are expected to perform relative to the market in general. We have a team of over 20 people that contribute to the performance of our funds. There are three fund managers [and] we three are the ultimate fiduciaries responsible for the performance of the fund.