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While they may never be a hot topic of conversation around the water cooler, municipal bonds have been quietly working their way back into the discussion for investors looking for any edge they can get on the fixed-income side of their portfolios. After falling out of favor in recent years due to declining rates and strong stock market returns, the stars may be aligning for municipal bonds as an attractive yield alternative, especially for tax-sensitive high earners and retirees looking for tax diversification of their income.

Better Yield Opportunities with Municipals

Yield-seeking Investors have languished for several years in a low-interest rate environment, often forced to look beyond the safe haven of investment-grade bonds for significant yield. Even as the Fed pushes short-term rates higher, a flattening yield curve continues to frustrate yield seekers. As of March 7, 2019, just 21 basis points separate the 10-year Treasury bond yield (2.64%) from the 3-month Treasury bill (2.45%). With the higher interest rate sensitivity of long-term bonds, why would investors assume the additional risk for less than a quarter of a point?

However, while the taxable yield curve continues to flatten, the corresponding yield curve for municipal bonds has been steepening. The yield curve spread for 10-year General Obligation AAA municipal bonds over the 2-year bond is nearly 70 basis points, providing investors with a greater contrast. Recent demand for shorter-term municipal maturities has pushed short-term yields down, while the lack of demand for and lower supply of longer-term maturities has helped to support prices, further narrowing the yield gap between taxable and non-taxable bonds. As of March 7, the yield on a 10-year Treasury bond is 2.64% as compared to a 2.10% yield on a 10-year AAA GO municipal bond.

Tax Equivalent Yields are Rising

Even after the reduction in federal tax rates, that translates into a very attractive opportunity for high earning investors. For investors in the 37% federal tax bracket, a taxable bond would have to yield 3.33% to equal the 2.10% tax-free yield of a 10-year AAA GO municipal bond. The equivalent yield would be higher when state taxes are considered municipal bonds are only state tax exempt if they are issued within your resident state). Even investors in the 25% tax bracket would generate an equivalent yield higher than the taxable bond yield.

A More Stable Fixed Income Alternative

As the current market illustrates, there is a low correlation between the performance of taxable bonds and municipal bonds. Whereas taxable bonds tend to act negatively to rising interest rates and inflation, municipal bonds are less sensitive, which can reduce volatility in the fixed income side of a portfolio. A big reason for the disparity is the different nature of investing in Treasury bonds versus municipal bonds. A large portion of the Treasury bond market is dominated by institutions and foreign investors utilizing sophisticated buy, sell and hedging strategies to minimize risk and optimize their returns. This has the effect of making the Treasury bond market more sensitive to macroeconomic events, which can increase volatility. Conversely, municipal bonds are primarily held by long-term investors seeking tax-free income, many of whom will simply hold their bonds until maturity. As a result, the municipal bond market is much more stable.

Credit Quality is the Biggest Issue

The larger concern for municipal bond investors is the financial quality of the issuer. Municipal bonds are second only to U.S. Treasuries in terms of perceived safety. However, while Treasury bonds are backed by the full faith and credit of the U.S. government, municipal bonds are only as secure as the financial strength of the issuing municipality or state. That smaller degree of security is why the tax equivalent yield on municipal bonds is higher than the actual yield on taxable Treasury bonds.

Although there have been some high profile bond defaults in recent years, such as Puerto Rico in 2016 and Detroit in 2013, municipal bond defaults are extremely rare. Over the last 50 years, there have been just 99 defaults – an annual default rate of 0.09%. That’s out of the thousands of municipal bonds issued across the country. Investment grade bonds rated “AAA” and “AA” experienced zero defaults.

While some cities and states are fiscally challenged these days, plenty earn the highest ratings from Standard & Poor’s and Moody’s. Ratings as low as “A” or “A1,” which offer higher yields, are still considered “high quality,” but it would be important to do additional due diligence on the fiscal soundness of the issuer.

How to Own Municipal Bonds

Municipal bonds can be purchased in denominations of $5,000 directly from an issuer or on the open market. As with any type of asset, it always advisable to diversify among several issues as a way to minimize potential risks. For smaller investors, the better option would be to invest in tax-exempt bond funds or exchange-traded funds (ETFs) that invest in a broad portfolio of state and local bonds. A typical fund will have over 100 bonds in its portfolio.

Bond funds charge an annual management fee, which can range from as low as 0.05% to as high as 1.5% for more actively managed funds. ETFs are traded much like stocks on the open market with transaction costs the same as buying or selling a stock. Another option is closed-end funds, which trade like ETFs on the open market. Because they sometimes sell at a discount to their net asset value, their yields can be higher than a typical bond fund or ETF.

Who Should Consider Investing in Municipal Bonds?

In the current environment, anyone who relies on income from a bond portfolio should consider allocating a portion to tax-exempt bonds. We already made a case for high earners who, by virtue of their higher tax bracket, can earn a higher after-tax return on tax-exempt bonds. The case is even stronger for high earners who live in high-tax states such as New York, California, and New Jersey. While individuals in these states enjoy the same slight reduction in federal income tax rates under the new tax law, it has been more than offset by the new $10,000 limit on state and local tax deductions. Tax-sensitive investors in these states have an extra incentive to reduce their taxable income.

The case can also be made for retirees who need to optimize their cash flow. For retirees, one of the biggest impediments to meeting long-term cash flow needs is taxation. Investing in tax-exempt bonds is a way to achieve tax diversification on income that can prevent retirees from being pushed into a higher tax bracket.

Considering the low-yield environment of late, municipal bonds have not been getting the attention they deserve. However, the current condition of a steepening municipal bond yield curve in the face of a flattening Treasury bond yield curve represents a compelling entry point for investors looking for an edge in their fixed income allocation. As with any investment that involved tax issues, it is always advisable to seek the guidance of a tax professional before investing any money. It is also recommended that you work with a qualified financial professional with experience in tax-free bonds.

Sources: $10,000 limit

The opinions and forecasts expressed are those of the author, and may not actually come to pass.

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