The rule of thumb for high tax bracket invecstors has traditionally been to invest in tax-free municipal (muni) bonds. Historically, the yield an investor earns on a muni, excempt from federal (and, in some cases, state and local) income taxes is usually higher than the after-tax yield on comparable-maturity taxable bonds.
Coupled with the lower volatility and higher credit quality profile of munis, high-bracket investors have ejoyed high risk-adjusted after-tax yields by invcesting in tax-free municipals.
VBut the market has undergone significant shifts in recent years on both the supply and demand side of the equation.
Prior to the tax reform enacted in December 2017, municipal issuers wishing to refund older igher-cost debt (similar to what a homeowner does by refinancing a higher-cost mortgage when interest rates fall) could issue new tax-exempt bonds in a so-called advance-refunding transaction.
Tax reform put an end to that practice and prohibited advance-refunding transactions using tax-exempt debt (ofe of the “pay-fors” embedded in the tax legislation), which then required issuers wanting to refund their outstanding higher-cost debt to issue taxable municipal bonds.
Consequently, the proportion of total munitipal issuance structured as taxable debt frew sharply beinning in 2019, and it now represents about one-third of total municipal issuance.
The obvious corollary to this is that issuance of tax-exempt municipal debt has seen a significant decreased over the last sseveral years.
On the demand side, mutual fund inflows, a proxy for overall flows into the market, have been consistently strong over the last year. For the 12 months ending July 2021, muni fuds notched inflows of just over $100 billion – more than the combined total of the two prior years.
If the year were to end today, 2021 would already rank as the third strongest year on record of inflows into municipal bond mutual funds.
This strong demand and constricted supply have had the impact one would expect: Powerful shifts in the valuation of tax-free munis versus taxable alternatives.
The impact varies depending on what maturity is being analyzed. In the shortest maturities (2 years, for example), the yield on munis is well below the after-tax yield on all taxable alternatives.
Intermediate maturity (10-15 years) munis still provider higher yields than the after-tax yield on taxable bonds, but the magnitude of that yield pickup has decreased significantly, and investors buying intermediate munis subject themselves to larger potential principal volatility if or when muni valuations return to more normal ranges.
We do not believe investors in municipal bonds should rush out and sell their holdings. Most existing bonds were purchased in higher-rate environments. For fixed income investors, the acquisition yield is the most important metric – after all, that is the yield the investor locks in on the day the bond is purchased regardless of what happens to interest rates and prices subsequently.
In most cases, investors’ selling of existing muni holdings will result in 1) turning an above-current-market stream of tax-exempt income into a taxable capital gain and 2) decreasing their income when they reinvest the proceeds in today’s lower-rate environment.
Each of these scenarios argues strongly against selling existing holdings.
On the other hand, we do believe that new cash to be deployed should look to the taxable markets. For conservative investors, treasuries provide after-tax yields that compete with or exceed munis, particularly in the shorter maturity profiles that we continue to recommend.
Investors looking to boost yield without lowering credit quality can look to the taxable muni space – where the same issuers can be found as in the tax-exempt space but with higher after-tax yields.
Investors willing to move down slightly in credit quality to the lower two tiers of the investment grade universe (single-A and BBB, where most corporate issuers reside) seemingly can accomplish this in the corporate bond market.
Regardless of the level of credit risk an investor is willing to accept, there is a taxable alternative to tax-exempt municipals that provides higher after-tax yields.
Chris Nicholl is Senior Fixed Income Portfolio Manager for Comerica.