Are municipal bonds really for me? The popular perception is that tax-exempt income only benefits those investors in the highest tax brackets. While that may have been true in the past, times have changed.
After-tax benefit for all
Municipal bonds have recently displayed an income benefit to investors across all marginal tax brackets. The expansion of the after-tax income advantage derives largely from the broad repricing of fixed income assets since the financial crisis. Massive fiscal and monetary stimulus since 2008, including bond buying on the part of the Federal Reserve (Fed), held Treasury yields at bay while propping up their prices. This meant that municipal bonds, which typically yield less than Treasuries before tax, began to offer yields higher or comparable to federal government debt on a pre-tax basis.
After tax, which applies to Treasuries but not munis, the income advantage is clear.
Consider that, as of the end of April 2016, the 10-year Treasury offered a yield of 1.83% while the Barclays Municipal Bond Index had a yield of 1.84%. For illustrative purposes (you can’t invest in an index), that 1.84% becomes 2.04% for those in the 10% bracket and 3.05% for those in the 39.6% bracket. Factor in the 3.8% tax on investment income under the Affordable Care Act and the yield for an investor in the highest tax bracket becomes 3.25%. Of course, past performance is no guarantee of future results and muni-to-Treasury ratios could change and, therefore, the outcomes could fluctuate.
If it’s income you seek, a look at the performance composition of the Barclays Municipal Bond Index also reveals municipal bonds to be a good proposition. Income (or coupon return) delivered more than 90% of the index’s positive performance from 2000 to 2015. Price return accounted for less than 10% of the index’s total return during that period. Income was able to help offset incidents of price deterioration. Other potential advantages to owning muni bonds include:
All fixed income assets have varying degrees of volatility, often driven by the interest rate backdrop and credit conditions. Munis (even the high yield variety) have been shown to experience lower volatility than other categories of bonds, including Treasuries and investment-grade corporates. They tend to be less affected by Fed rate uncertainty than Treasuries and have benefitted from firmer credit conditions at the low end of the quality spectrum (high yield). In 2015, 10-year cumulative default rates stood at 0.24% for municipals vs. 11.16% for corporate bonds, according to data from S&P.
Ballast to equity risk
Munis have a negative correlation to the S&P 500. Our analysis found that in the 11 months since 2010 in which the S&P 500 Index was down more than 2%, municipal bond funds were up an average of 0.8% — which was more than taxable bonds.
High yield municipals have also shown to be uncorrelated to high yield corporate bonds. In 2015, when collapsing energy prices weighed on corporate high yield and contributed to rising defaults, taxable high yield bond funds lost 4%, according to Morningstar data. High yield municipal funds were up by nearly the same amount.
Munis have notched 10 consecutive months of positive returns through April 2016. We see good reason for the longer-term trend to remain positive and would view any short-term pullback in the asset class as a buying opportunity.
Like many other investors who have crossed over to the tax-exempt side of the market, now may be a good time to think about whether municipal bonds deserve greater representation in your investment portfolio.