By Fidelity Viewpoints
Until the financial crisis of 2008, a municipal bond that offered more yield than a comparable Treasury was a rare bird. Indeed, because interest from munis may be federally tax exempt, it was often said that munis were attractive when they yielded more than 80% of Treasuries—a level that was about the historical average. Now, many municipal bonds have ratios that can be 100% of their corresponding U.S. Treasury bond yield, and, although the tax impacts of municipal bonds may be complicated, particularly for retirees, these bonds still have the potential advantage of tax-exempt income.
Higher tax-equivalent yields and the potential for tax-free income make this a great time to look at municipal bonds.
Here are three key reasons to consider munis now, particularly if you find yourself in a top tax bracket.
1. Higher yields than Treasuries. As of March 13, 2015, the yield on a 10-year Treasury bond was 2.09%, while the yield on munis with the highest credit rating, AAA, reached 2.64%. Of course, that is before accounting for the tax benefits of municipal income. For an investor in the 35% federal tax bracket, the muni provided the equivalent of a Treasury yielding slightly more than 4%.
It is not an isolated incident. In recent years, muni bonds have frequently offered higher tax-equivalent yields than Treasuries for investors in most tax brackets—and in many cases higher pretax yields as well.
Global demand for U.S. Treasuries and bond buying by the Federal Reserve has been a key driver of the shift in relative rates. The U.S. government has been a huge buyer of bonds as part of its stimulus program. A shrinking deficit has also reduced supply of new debt. Meanwhile, even lower interest rates and currency concerns in Europe and Japan have attracted foreign investors to Treasuries for higher yield and exposure to the U.S. dollar. Demand from foreign investors and the Fed has outpaced the net new issuance of Treasuries, leading prices up and yields down.
While Treasury rates have been suppressed by strong global demand, the dynamics are different in the muni market. Many foreign investors simply do not invest in the municipal market, says Cummings. Therefore, munis may offer an attractive yield pickup for investors looking for more yield in today’s low-rate environment.
2. Adding munis may help manage risk. Many investors turn to the bond market to help manage the risk of a stock portfolio. Munis may offer a couple of potential advantages for an investor looking to add diversification.
Diversification cannot guarantee a profit or ensure that you won’t experience a loss, but adding investments that tend to perform well in different market conditions can help manage the overall risk of a portfolio, as one investment may perform well while another struggles.
Like taxable bonds, munis have a very low correlation to stocks. This means they have the potential to add diversification to a stock-heavy portfolio. But adding munis may offer a second diversification advantage. Over the past 20 years, municipal bonds and investment-grade taxable bonds have outperformed one another at different times. As you can see in the table, munis and taxable bonds are not perfectly correlated—a correlation of 0.6, well below a perfect correlation of 1.0. This means that adding both to your investment mix may help to balance risk in your overall portfolio.
Most investors understand the potential benefits of diversifying between stocks and bonds. What may be less understood is the case for diversifying within an asset class. Adding munis to a bond portfolio may be able to help reduce the risk of a portfolio.
3. Higher taxes add to munis' appeal. Munis have always held appeal for investors in higher tax brackets because, in many cases, they produce income that is federally tax exempt. In recent years, the benefits of tax-exempt income have increased as tax rates have gone up. Since 2013, tax rates on the highest-income earners have been raised to 39.6% and some investors have run into the Medicare surtax on net investment income, which can increase taxes another 3.8%—for a top rate of 43.4%.
How big a difference do the new tax rates make? Let’s say your tax rate went from 35.0% to 39.6%. That 4.6 percentage point change shifts the math for municipal bonds. For instance, say you were considering a municipal bond offering 2.8%. If you paid 35.0% in taxes, that would be equivalent to a taxable bond yield of 4.16%. If you paid taxes at 39.6%, the muni would offer an after-tax yield of 4.49%. Add in the Medicare surtax and your tax-equivalent yield would be 4.95%.
While munis generally offer income that is exempt from Federal income taxes, and in some cases state income taxes, the tax impact for some retirees may be more complicated. Muni income, while it may be exempt from income taxes, still counts towards modified adjusted gross income (MAGI) for the purposes of Medicare and Social Security. If your MAGI passes a key threshold ($170,000 for couples filing jointly in 2015), you will be charged higher Medicare premiums for part B and prescription drug coverage. If your municipal income pushes your MAGI over $32,000 for a couple filing jointly, some portion of your Social Security benefits will become taxable. You should consult a tax advisor if you have questions.
The bottom line. The market for bond investors is always changing. But recent shifts in bond market dynamics, the interest rate outlook, and federal tax rates may make now a good time to consider how municipal bond income fits into your diversified portfolio.
******
The D2 Capital Management Tax Free Income Portfolio is currently yielding 4.431% (Trailing 12 month Tax Equivalent Yield at 28% Tax Bracket, as of 8 April 2015). Year to date the portfolio is up 1.04%
The views expressed here are that of myself or the cited individual or firm and do not constitute a recommendation, solicitation, or offer by myself, D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.
