Are Income Investors Better Off in Municipal Bonds?

For the past decade interest rates have been at historically unprecedented low levels. Although the Federal Reserve steadily increased rates since 2016, it abruptly reversed course in January and has cut rates twice since then.

Paltry yields available have forced investors into dividend-yielding stocks or the bond market, where the coupon rates have been negligible.

Rates have been so depressed on corporate and government bonds that yield-starved investors have turned their attention to the tax-free municipal market.

Municipal bonds are debt instruments issued by state governments and local municipalities. The interest on municipal bonds are exempt from federal and in some cases, state income taxes.

The interest payments on debt issued by quasi-governmental bodies created by statute, such as as local water resource and housing authorities, also are tax-free.

Tax-free municipal bonds have long been an investment staple for individuals in high tax brackets. For comparing yields, it should be noted that interest income on Treasury bonds is exempt from state but not federal taxes.

In light of their tax advantages, municipal bonds carry lower rates than taxable corporate debt obligations. As interest rates on corporate as well as debt of the federal government have steadily decreased, the rates on municipal bonds relative to taxable debt instruments have started to look appealing, not only for high net-worth individuals but for all investors.

An examination of a chart of the yield curve below explains why.

Indeed, according to data from Thompson Reuters Lipper, investors of all stripes have poured money into municipal bond mutual funds for 32 consecutive weeks, reaching a total of $59.3 billion for the year through late August.

The yield curve has been on a downward trajectory since 200 and rates continue to hit new lows. Recently the rate on the 10-year Treasury note dropped below 2%, its lowest rate ever.

Given these conditions, over the past year municipals bonds started to grab investors’ attention. One measure of the current tax-free yields available is indicated by the Bloomberg Barclays Municipal Bond Index ETF, which currently has a yield of 2.1%.

In a dismal yield environment, munis may provide investors with comparable tax-equivalent yields that surpass the coupon rates of many corporate and government bonds. Investors should carefully review the issuing municipality and decide whether the current interest rate available exceeds that offered by existing taxable bonds.

Those considering an investment in municipal bonds should note that, for comparison purposes, the higher your tax bracket, the higher the tax-equivalent yield will need to be.

For investors who will remain in a high tax bracket when they retire and need supplemental income, munis might provide a suitable and safe investment that could provide a reliable stream of tax-free payments.

Bonds with longer maturities generally carry higher interest rates. Investors should review the available yields on longer maturities and lock-in the higher yields on the longer dated bonds.

Muni risks

Municipal bonds are rated with the same scale used to assess the risk of corporate debt issues. Those local or state governments with poor fiscal health will have lower ratings and, in most cases, higher yields.

One benefit of municipal bonds that makes them attractive, is that the debt is backed by the full faith and credit of the issuing municipality.

The local government or authority that sells its debt to investors has the taxing power available, should additional revenue be needed to pay the semi-annul interest due on the bonds. Bonds issued by private corporations don’t have this tax-levying power available.

In this regard, it is instructive to note that the default rate on corporate bonds is 6.7%.

In comparison, according to bond rating firm Moody’s, though muni defaults have become more common recently, the municipal default rate has been about 0.1% since 1970.

High-yielding munis

Investors willing to assume greater risk can examine the generous tax-free yields currently available on some unique tax-free bonds that are riskier than the traditional municipal debt.

An example of high-yielding municipal debt are bonds issued for charter schools, nursing homes and real-estate development projects. The Pimco High Yield Municipal Bond Fund currently yields 3.9% and has a 52 week return of 8.44%.

These high-yield non-investment-grade tax-free bonds carry more risk than higher rated debt. According to Municipal Market Analytics, approximately 2.5% of unrated bonds are currently in default. This is still below the 6.7% default rate for corporate bonds, as noted above.

Data from FactSet shows that high-yield munis outperformed corporate bonds, stocks and Treasury bonds last year. They have returned 5.5% this year, counting price increases and interest payments.

High-yield corporates, by comparison, have returned a taxable yield of 8%.

Limited supply

The number of municipal bonds currently on the market can’t keep up with the demand; the result is prices have increased steadily over the past year, as investors flock to the relatively higher comparable yields of tax-free investments.

However, as the new supply of issues dwindles, the swelling demand has an impact on the yield. Because the demand has far outstripped available supply, municipal bond prices have steadily risen. Additionally, regardless of supply, bond prices rise when interest rates drop.

How much have yields declined?

In an August 15th report to its clients, UBS noted that yields on 10-year municipal bonds with AAA ratings fell by 0.36 percentage point to 1.22%, while yields on 30-year AAA rated bonds have decreased by 0.41 percentage point to 1.87%.

Those investors who entered the municipal market approximately six months ago were rewarded for their auspicious timing with generous total returns.

Not only were the coupon rates attractive compared to taxable bonds, but as the Federal Reserve started cutting rates in January prices on the tax-free munis started to rise.

These early-to-the-game investors got both tax-free income and capital appreciation. For example, the SPDR Nuveen Bloomberg Barclays Municipal Bond ETF has a current yield of 2.17% and a total 52 week return of 8%.

Investors contemplating purchasing bonds now should understand that they will probably not receive total returns comparable to those available several months ago.

The municipal bond market environment has changed and is now a sellers’ market. Income investors should note that as of August, the 1.95% yield on the Bloomberg Barclays Municipal Bond Index is slightly above its lowest level since 2017. This is its lowest yield since October 2016 and is a drop from its recent peak of 3.08% in November.

Investors seeking to maximize tax-free yields in an uncertain and volatile market might consider an ETF municipal bond fund. The fund manager could respond timely and appropriately to the direction of the yield curve, with the goal of seeking to increase the fund’s total return.