The Case for Tax Free Municipal Bonds
Co-Author: Zachary Smith, Fixed Income Analyst
Over the past six months, the Federal Reserve has reduced the Federal Funds rate by 1% to a range of 4.25%-4.50%. Rather than follow the Federal Funds rate lower, intermediate-term treasury yields have actually increased by more than 50 basis points, as the slope of the yield curve began to normalize resulting in longer-term Treasury rates rising above shorter-term ones. Municipal bond yields, which are much higher than they were three plus years ago when they were yielding below 1%, have basically stabilized around the 3% level. This makes tax free municipal bonds very attractive relative to Treasuries and corporates for someone in the highest federal tax bracket and even more so for those living in a high-income tax state.
Comparing municipal bonds yields to other bond rates requires an adjustment for personal tax rates. The equivalent yield on a taxable bond or “tax equivalent yield,” for those in the highest federal tax bracket and living in high tax states, would be 6% or higher, a yield that is considerably above alternative high quality, investment-grade fixed income securities. As a reminder, the highest federal tax bracket is 37%. Interest from other fixed income instruments, such as corporate bonds, CD’s and money market funds is also subject to a 3.8% Net Interest Income (NII) tax, which brings the total federal tax rate to 40.8%. Add to that 9% (or greater) state income tax rates in a number of states and many investors are paying a marginal tax rate of 50% or higher on most taxable bonds. Even for those living in states with no state income taxes, the tax equivalent yield of intermediate maturity municipal bonds today is likely equal to or greater than 5% for anyone in the highest federal tax bracket. On a relative value basis, yields on A-rated municipal bonds have traded in a range of approximately 60% – 80% of US Treasury yields over the past four years and over the longer-term history except for the zero interest rate and Covid periods. Very recently, however, municipal bond yields have risen to approximately 75% of Treasury yields. Note that this ratio can be volatile and today’s yields are offering investors an unusual opportunity.
Besides the attractive relative yield of municipal bonds, strong credit quality also bolsters the appeal. Defaults remain rare in the municipal bond universe, as a study by Moody’s pegs the 10 year default rate for investment-grade munis at 0.1% and even lower for those rated A- or higher. These historical default rates are meaningfully below those of comparably rated corporate bonds. State and local budgets, flush from post-pandemic stimulus and resilient tax revenues, support this stability.
Unlike Treasuries, CD’s, and money market funds, tax free municipal bonds are often challenging for retail investors to purchase because there are tens of thousands of issuers and hundreds of thousands of individual issues of municipal bonds. Municipal bonds also differ by funding sources, duration, call provisions, and other details. Munis may be tax-free, but they are not free of complexity. It is important to understand what you own, when it may be called away, what the tax implications are, etc. Retail investors are also often limited to the inventory available from their broker/dealer.
Our approach to selecting municipal bonds for clients brings together deep analysis of the available securities, examines both absolute and relative value, considers risks and bond provisions, and leverages our capability for sourcing bonds through our trading desk. At ACM, we have found it beneficial for clients to own individual securities, as it allows the ability to hold bonds to maturity, if desired. This stands in contrast to the alternatives available to most retail investors: owning municipal bond mutual funds or ETF’s, which expose investors to increased volatility as fund managers are often forced to sell bonds at inopportune times, which can result in unnecessary losses or taxable gains to investors of the fund or ETF. The ACM Muni Bond Strategy is customized to meet each client’s objectives. We can manage a state-specific portfolio in any state in the country, a national portfolio for those clients in states that have no state income tax or any blend of the two (with a state preference). We choose to only invest in municipal bonds that have an underlying credit rating of A- or higher, regardless of insurance coverage. Many of the bonds in each portfolio are double-barreled, which means that they also have A-rated insurance on top of their own credit. We focus on general obligation bonds which are backed by the full faith and credit and taxing authority of each municipality and we invest in essential service revenue bonds such as power, electric, water, sewer and school district bonds. We avoid airports, healthcare facilities, housing developments, and sports and convention center bonds as these four areas have the highest historical default rates. This makes the ACM Municipal Bond Strategy among the highest quality and most conservative in the industry. Municipal bond management is also available at ACM as a fixed income allocation of a balanced portfolio, along with high quality equities in our Private Balanced Total Return strategy.
While ultra short treasury bonds still have interest rates above 4% today, most high-quality money market funds are yielding below 4% today and likely headed lower. Furthermore, a focus on short term yields exposes investors to significant reinvestment risk, if rates decline. Investors today have an enticing opportunity to lock in attractive tax-free municipal bond yields in a portfolio with a duration of 3-4 years that results in tax-equivalent yields of approximately 5%-6% for those in high tax brackets. This allows investors to secure above average tax-free yields for a number of years without taking much credit or interest rate risk.
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