After a hot streak in 2014, municipal bond performance cooled in 2015. The Barclays Municipal Bond Index was up less than 2% through early October 2015, compared with a 9% rise in full-year 2014.1 However, municipal bonds still deserve consideration in your portfolio, as they can offer valuable benefits, including tax savings and relatively attractive after-tax yields.
Municipal bonds are issued by state, city and local governments to fund daily operations or specific projects like roads, bridges or hospitals. Their primary attraction for investors is that the interest they pay is usually exempt from federal—and often state and local—income tax. Simply put, an investor in the 28% federal income tax bracket would have to earn 28% more interest from a Treasury or corporate bond to match the benefit of investing in a tax-free municipal bond (assuming all these investments are made in a taxable account).
Because of their tax advantages, municipal bonds historically have offered lower yields than taxable bonds. But that hasn’t been the case in recent years. As of early October, the average yield on a 10-year muni was 2.1%, identical to the yield on a 10-year U.S. Treasury bond.2 The muni bond’s tax exemption can give it an advantage, even if both bonds offer the same yield.
What’s the downside? For one, there have been a number of high-profile muni defaults recently. Puerto Rico defaulted on some of its debt in August 2015, for instance, while Detroit began skipping bond payments prior to its 2013 bankruptcy filing. Defaults on municipal bonds historically have occurred far less frequently than defaults on similarly rated corporate bonds,3 but investors should be aware that a meaningful risk exists.
Rising interest rates also could have a negative impact, though this may be true for most bonds, not just munis. Bond prices move inversely to changes in interest rates, so a rise in rates could be negative for muni bond prices.
Nevertheless, muni bonds can be an attractive alternative to Treasuries and corporate debt for investors seeking to maximize after-tax yield. To reduce the already low historical risk of default, consider sticking with highly rated bonds (A-rated or higher) or choosing active management via mutual funds or other investment options.
1 Barclays. The Barclays Municipal Bond Index year-to-date return was 1.88% as of 10/7/2015.
2 Bloomberg, U.S. Department of the Treasury. Data as of 10/7/2015.
3 Moody’s Investors Service, “U.S. Municipal Bond Defaults and Recoveries, 1970–2014,” July 24, 2015. Default rates only include bonds rated by Moody’s.