Fixed-income investing has garnered more attention lately as yields have risen dramatically over the last 12 months, reaching levels not seen since the Great Recession of 2007-2008. Current yields on U.S. Treasuries are now trading between 4% and 5% and have pushed other high-quality fixed-income assets, such as municipal bonds and corporate bonds, to yield levels not seen in many years. Collectively, this is attracting increased demand for fixed-income securities.
A recent Morningstar report showed that the only investment category to post positive fund inflows for 2023 was fixed income, which added $395 billion to bond funds. More recently and specific to municipal bonds, the Investment Company Institute reported that $8.35 billion flowed into municipal bond mutual funds and ETFs during the first 10 weeks of this year. That was the largest 10-week cumulative flow into municipal bonds since January of 2022.
This increase in demand has clearly benefited the municipal bond market year-to-date. The total return on the Bloomberg Municipal Bond Index is -0.22% as of March 22, while the Bloomberg Treasury Index is down much more, -1.18%, and the Bloomberg Corporate Bond Index is off -0.65%. Given such strong relative performance, sectors within the municipal bond market could be considered overbought for some investors, so proceed with caution.
One of the major advantages of owning municipal bonds over taxable bonds, such as corporates and Treasuries, is the tax-free income. Because of this advantage, the yield on municipal bonds typically trades much lower than comparable taxable bonds.
As an example, the yield to worst of the Bloomberg 1-10 Year Municipal Bond Index was 3.04% as of March 22. This may be an attractive yield for investors who are subject to the highest marginal federal income tax rate of 37% combined with the 3.8% Medicare surcharge. By calculating the taxable equivalent yield of a municipal bond yielding 3.04% and assuming an all-in federal income tax rate of 40.8% (37% plus 3.8%), you get a tax-equivalent yield of 5.13% [.0304 divided by (1-.408)].
If investors can find a taxable bond that yields more than 5.13%, they would be better off buying the taxable bond and paying the tax, rather than buying a tax-exempt municipal bond at 3.04%. This assumes the two bonds are comparable in risk and the investor is not subject to any state income tax. The tax-equivalent yield calculation provides a simple framework to compare a tax-exempt bond to a taxable bond.
As a result of the recent relative out-performance of the municipal bond market, the yields on municipal bonds have declined. They’re at a point where the tax-equivalent yield on some of the highest-quality, AAA-rated municipal bonds are now trading below that of comparable Treasuries yields on an after-tax basis – making Treasuries a better alternative for investors who pay high taxes.
One way in which the bond market measures municipal bond relative value is by the AAA muni-to-Treasury yield ratio. This is calculated by using the yield to worst on a AAA-rated municipal bond and dividing it by the yield on a comparable maturity Treasury bond. When the ratio drops below 59.2% (1-40.8%) all-in federal income tax rate), investors in the highest marginal tax rate should prefer Treasury bonds, as they get paid more after paying federal income taxes.
The chart below shows both the 5-year and 10-year maturity AAA-rated muni-to-Treasury yield ratios over time, and it should be noted that both are currently below the 59.2% break-even ratio. This indicates that high-quality municipal bonds, specifically AAA-rated bonds, may be overvalued.
In addition to considering Treasury bonds as an alternative to municipals, investors in the highest income tax brackets should also consider corporate bonds. The additional after-tax yield that some corporate bonds can offer is higher than some comparable municipal bonds, even for those paying state income tax.
Unlike Treasury bond income, corporate bond income is taxed at federal, state and possibly local levels. As such, any relative value analysis should include the investor’s specific all-in marginal income tax rate. The chart below shows the current after-tax yield for the Bloomberg Intermediate Corporate Bond Index, applying only the highest federal income tax rate, and compares it to the yield on a similar maturity municipal index, the Bloomberg Municipal 1-10 Year Blend Index.
The average after-tax yield on the intermediate corporate index is now higher than the average yield on the comparable maturity municipal bond index. Even if we were to apply a moderate state income tax rate to the calculation, opportunities can still be found in some taxable corporate bonds.
The selection between any specific municipal and corporate bond should include comparisons of risk metrics such as maturity, duration, liquidity and bond structure, as well as a thorough credit review. Credit agency ratings are important but should not be solely relied upon for such an analysis.
Municipal bond investors should proceed with caution. The traditional approach for high-net-worth investors – exclusively buying municipal bonds – should be questioned.
It is important that any investment, be it bonds or other asset classes, be reviewed on an after-tax basis that is specific to the individual investor. If done properly and combined with the appropriate due diligence, attractive investments can be found. Given the renewed affection for fixed income, it is important that investors bear this in mind to make the best of current market opportunities.
