Muni Bonds: Still Attractive Even With Tax Reform

Key Points

  • Investors in higher tax brackets may want to consider munis for their tax benefits and generally high credit quality.
  • For the core of a muni portfolio, we prefer a mix of general obligation bonds backed by a dedicated tax pledge and revenue bonds backed by an essential service.
  • For the best balance of risk and reward in the muni market, we favor targeting an average maturity of between five to 10 years.

The last election left some municipal bond investors wondering if potential policy changes might pull the rug out from under the market. Two possibilities stood out: That large tax cuts could erase the tax benefits that are central to munis' appeal. And that a surge in infrastructure spending could flood the market with new issues. Combined, such changes could hurt muni portfolios.

Things haven't quite worked out that way, at least not yet. The prospects for tax cuts and an infrastructure boom are still far from certain. And munis have actually done quite well in the interim, returning more than 5% so far this year and outperforming both treasury bonds and the broad fixed income market.1

So does the possibility that things could still change mean you should avoid munis? We don't think so. Munis' tax benefits and generally high credit quality continue to make them an appealing option for investors in higher tax brackets.

Investors in higher tax brackets benefit from tax-exempt income

Interest payments on muni bonds are often exempt from federal income taxes, as well as the 3.8% tax on net investment income that was enacted as part of the Affordable Care Act. In addition to federal tax benefits, interest payments are also generally exempt from state and local income taxes for many municipal bonds purchased in an investor's home state.

Once you factor in the potential tax benefits, you may receive a better yield with munis than with comparable taxable bonds. Investors in higher tax brackets could see the biggest benefits.

The chart below shows how taxes affect the yields of taxable corporate bonds relative to munis. We start with a broad corporate bond index with a yield-to-worst of 3.1% and a muni index with a yield-to-worst of 2.1%.2 Then, we show how various state and federal tax rates, as well as the 3.8% ACA tax, chip away at the after-tax yield of the corporate bond index. As you can see, for investors in the 33% tax bracket, the yield on the corporate bond index is actually less than that from the muni index. The advantages grow from there.

A yield comparison 

The after-tax yield-to-worse of the corporate bond index drops from 3.1% to 1.9% for investors in the 33% tax bracket, 1.8% for investors in the 35% bracket and 1.6% for investors in the 39.6% bracket.

Source: Bloomberg Barclays Municipal Bond Index and Bloomberg Barclays Corporate Bond Index, as of 8/18/17.

Note: After-tax corporate bonds include an additional 5% state income tax and 3.8% tax for the 33%, 35% and 39.6% tax brackets. Yields for municipal bonds are generally lower than those for corporate bonds to account for the differences in taxation.

So what if things changed? In March, the White House unveiled a plan that would cut the number of tax brackets down to three, with the highest rate being 35%. Based on current interest rates, munis would still yield more than corporates or Treasuries after taxes for investors in this highest bracket. Also, since Congress could not repeal the ACA, the 3.8% tax on net investment income is still law. Even in its last effort to repeal the ACA, the senate’s bill did not repeal the 3.8% ACA tax.

Historically, munis have rarely defaulted

After several highly publicized problem cases involving Detroit and Puerto Rico, one could have the impression that muni defaults are commonplace, but that is not so. Historically, munis have been less likely to default than similarly rated corporate bonds, as shown in the chart below. In fact, only $33.3 billion of the entire $3.5 trillion muni market defaulted for the first time in 2017. Puerto Rico issuers accounted for all but $0.6 billion of the total.3 Excluding Puerto Rico, only 0.02% of the market defaulted for the first time this year. Puerto Rico’s defaults didn’t come as a surprise to many muni market participants. The territory’s problems were well known and the issuers that defaulted had already been downgraded deep into junk territory prior to defaulting.

Defaults for investment grade munis have historically been rare

Muni defaults have historically been far lower than those for comparably rated corporate bonds.

Source: Moody’s Investor Services, as of 6/27/2017.

We are generally positive about credit conditions for most state and local government issuers and think the trend should continue. For example, the year-over-year growth in state and local government employment has been positive for 46 straight months, which is a sign to us that in aggregate financial conditions for state and local governments are stable. State and local governments, unlike the federal government, must balance their balance sheets annually and one way of doing this is reducing expenses like employment.

We currently favor an average maturity between five and 10 years for munis

When judging the relative attractiveness of municipal bonds, we usually compare them to Treasury bonds by looking at the municipals over bonds (MOB) spread. This is a way of comparing the yield on a muni bond to a Treasury of equal maturity before accounting for taxes. Earlier this year, the 10-year MOB spread was close to 100% but has since declined to 86.1%, thus reducing the attractiveness of munis relative to Treasuries before taxes. The MOB spreads for all maturities have been below their averages since the end of 2010, and spreads for shorter-term maturities are particularly low, as shown in the chart below.

Spreads for shorter-term munis are far below their longer-term averages

The munis-over-Treasuries yield ratio for shorter-term munis is far below its historical average.

Source: Bloomberg, as of 8/23/17.

Normally, we would suggest matching your investments’ maturities with when you need the money, which in this case would involve investing money you’ll need in the next few years in short-term munis. However, because the short end of the muni yield curve is unattractive relative to historical averages, we would suggest considering alternatives such as Treasuries or certificates of deposit.

Of course, you’ll want to keep the tax implications in mind because CDs and Treasuries are subject to income taxes. For investors in higher tax brackets, munis may still be a more attractive option than CDs or Treasuries.

We believe you should consider highly rated “GOs” and revenue bonds

The muni market is large, with many different issuers, which can make it seem overwhelming. That’s why we try to narrow the scope down to two types of bonds in particular:

  • General obligation (GO) bonds are backed by a specific tax source or the full faith and credit of state and local government general revenues. GO bonds backed by a specific tax pledge, such as a property tax, are generally preferable, in our view, to GO bonds with a general full faith and credit pledge.
  • Revenue bonds are secured by revenues from a specific service, not taxes (generally) or the revenues of a state or municipal government. We generally suggest focusing on bonds with a specific revenue source—in particular those backed by services users can't do without, such as water or sewer.

These bonds have different characteristics, but both can help provide diversification for investors' portfolios.

For the core of a municipal portfolio, we generally suggest sticking with a mix of GO bonds from well-established issuers with stable populations and diverse economies, and revenue bonds that are backed by a “monopolized’ service” such as water and sewer revenues. More aggressive muni investors may want to consider adding issuers that exhibit a high degree of business risk—such as hospitals—because they generally offer higher yields but also higher risks.

If you’re looking for professional help, work with a Schwab representative to find the right investments for you. Schwab also offers a breadth of professional portfolio solutions for all or part of your municipal bond portfolio.

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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