5 Factors to Consider With Taxable Munis

There's a small portion of the bond market that investors may have overlooked but now may want to consider—the taxable municipal bond market. 

Most munis pay interest that is exempt from federal and potentially state income taxes. However, interest on some municipal bonds is subject to both federal and state income taxes. These bonds, known as taxable municipal bonds, generally pay higher interest rates than tax-exempt munis to make up for the lack of tax benefits.

Taxable munis have been among the hardest hit fixed income asset classes this year, but we believe the sharp selloff has created opportunities. Taxable munis look attractive to us because they can offer investors higher yields without having to take on too much additional credit risk. Below are some of the primary reasons we think some investors should consider taxable munis.

Yields for taxable municipal bonds are attractive, in our view, compared to both corporate bonds of similar maturity and credit quality and tax-exempt munis. Since taxable munis pay interest that is subject to federal income taxes, they often have higher yields than tax-exempt municipal bonds. Today, that difference is elevated relative to its longer-term average. Taxable municipal bonds may be an attractive option for investors in lower tax brackets or for tax-sheltered accounts like an individual retirement account (IRA).

In addition to being attractive relative to tax-exempt munis, highly rated taxable munis are attractive relative to highly rated corporate bonds, as illustrated in the chart below. However, as you move down to credit spectrum to A-rated and BBB-rated issuers, the yield advantage fades. It's also important to note that these yields are based on indices, and there may be differences when comparing individual bonds.

Another potential benefit of taxable munis is that they're generally higher in credit quality than the alternatives. For example, 78% of the taxable muni market is rated in the top two rungs of credit quality. This compares to 72% for the tax-exempt muni market and only 7% of the corporate market, as illustrated in the chart below.

This is notable for investors because higher-rated issuers tend to default—that is, to miss an interest or principal payment—less frequently than lower-rated issuers. For example, over a five-year period ending in 2019, 0.5% of Baa rated munis defaulted, according to Moody's Investors Service. During the same period, lower-quality B rated munis defaulted 25 times more often, at a rate of 12.2%.

Moreover, municipal bond issuers, which include issuers of taxable munis, tend to default less frequently than corporate bond issuers. Looking at the Baa rated cohort, the default rate for munis was 0.5%, compared with 1.5% for corporates.

The bottom line is yields for taxable munis are higher than most taxable alternatives, yet you generally don't have to accept greater credit risk to get those higher yields.

However, taxable munis do have some risks. Here are three of the most prominent:

Although issuance has risen recently, the taxable muni market is much smaller than many other fixed income markets, as illustrated in the chart below. Smaller markets are generally less liquid than larger ones, like the Treasury market, which means that it can be more difficult to sell your bond if you need to. Therefore, we suggest that if you're considering taxable munis, hold them until maturity. The smaller market and lower liquidity of taxable munis is also an issue for investors in funds like exchange-traded funds (ETFs) or mutual funds.

Due partly to the size of the market there aren't many mutual funds or ETFs that invest solely in taxable municipal bonds. In fact, there is only one open-ended ETF that we know of that invests in taxable municipal bonds and doesn't use leverage. Bonds that are less liquid are generally more volatile in times of market stress.

In addition to being a smaller market, the taxable muni market is dominated by issuers in three states. Issuers in California, Texas, and New York account for over 40% of all the taxable munis in the taxable muni market.

Nearly one-third of all taxable munis are small issues and therefore not eligible to be included in the broad taxable muni index. This is important because passive strategies like ETFs that track the benchmark will generally not invest in these smaller issues, which can reduce some diversification benefits.

First, the taxable muni index has a longer average duration—which makes it more sensitive to changes in interest rates—than the tax-exempt index. For investments such as ETFs or passively managed mutual funds that simply track the index, investors are taking on greater interest rate risk with taxable munis compared to tax-exempt munis. This is the main reason taxable munis have underperformed other fixed income investments this year. If rates rise more than we expect, total returns for taxable munis would likely underperform their tax-exempt counterparts even more.

For investors in high tax brackets, we generally don't see value in taxable munis. However, investors in lower tax brackets or those investing a tax-sheltered account like an IRA may want to consider a small allocation to taxable munis to complement their other fixed income holdings.

Schwab clients can log in to their accounts and search for individual taxable munis using the "Federally Taxable" dropdown menu under "Search by Product" on Schwab Bond Source on Schwab.com. Clients can also search for funds like ETFs or mutual funds on Schwab.com that invest primarily in taxable munis. If you need additional help, reach out to a Schwab Fixed Income Specialist for guidance in selecting the investments that are right for you.