10 reasons muni bonds have the potential to hold strong value for taxable investors

December 2, 2014 Categories: Portfolio Corner
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We’ve previously written about the attractiveness of municipal bonds relative to corporate bonds; fast forward to October 31, 2014, and much of what we advocated has come true. Without retelling the story, the gist of the article explained that the yield of the Barclays U.S. Corporate Investment Grade Index, a taxable index, was nearly identical to that of the Barclays Municipal Bond Index, a tax exempt index. This is an anomaly that, unless driven by fundamentals, would not be expected to persist due to the tax benefit of municipal bonds. At that time, we felt that there was a potentially attractive opportunity in municipal bonds for both tax aware and tax exempt investors.

From October 1, 2013 to September 31, 2014, the Barclays Municipal Bond Index returned 1.16% more than the Barclays U.S. Corporate Investment Grade Index from an absolute return perspective, a notable amount considering the current low interest rate environment. On an after-tax basis, the difference is even greater. Today, however, the ratio of municipal bond yields to corporate bond yields is more normal (closer to 70%, about 6% inside the historical 10-year average), making tax-exempt municipal bonds appear less attractive to typical tax exempt investors. The updated chart that we presented previously is below:

10 year muni corporate yield

Source: Barclays Live. Barclays Municipal Bond Index and Barclays U.S. Investment Grade Corporate Index. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

That being said, we still believe that tax-exempt municipal bond funds have the potential to hold strong value for certain taxable investors today. Here are 10 reasons why we feel this way, even when acknowledging that past performance is no guarantee for future returns::

  1. Fundamentals appear to be improving. Revenues in many states are increasing, helping to replenish reserves lost during the 2008 financial crisis.1
  2. Historically, default rates for municipal bonds are low. Even within BBB-rated municipal bonds, the historical default rate is lower than the AAA-rated corporate bond default rate.2
  3. A-rated and BBB-rated municipal bonds are attractive relative to A-rated and BBB-rated corporate bonds. The yield ratios are 88% and 94%, respectively, as of October 31, 2014.
  4. Municipal bonds have historically tended to be defensive in a rising rate environment.* In a simple hypothetical example, if you assume a 75% yield ratio (a municipal bond yields 2% and an investment grade corporate credit yields 2.67%) and yields rise 1%, by default municipal yields should only rise 0.75%, (or 75% of whatever rate rise in the broad market) to maintain the same yield ratio that exists due to the tax exemption.
  5. Although both indexes used for this example included only investment grade bonds (BBB or higher), the average credit quality of the municipal bond index (AA3/A1) is currently higher than that of the U.S. corporate bond index (A3/BAA1), as of October 31, 2014.
  6. Sentiment is much improved over 2013, with modestly positive fund flows throughout 2014 and net negative supply (more bonds matured relative to new issuance).3 We acknowledge that the retail nature of municipals can make sentiment volatile. We believe net negative supply is widely predicted into the future, and has been a consistent pattern in recent years.
  7. Depending on the investor’s tax bracket, the 70% yield ratio may still be attractive on an after-tax basis. Municipal bond income may be taxable on the local or state level. In some instances, income may also be subject to the Federal Alternative Minimum Tax
  8. We acknowledge pension issues are present and need to be solved, but in our view, revenue-backed bonds have the potential to help manage that risk in certain types of portfolios
  9. Puerto Rico, the financially troubled and headline making commonwealth, is largely removed from the investment grade municipal bond index. Puerto Rican insured bonds, backed by investment grade monoline insurers, are still present in the index.
  10. Because investors are worried about rising rates, Municipal/Corporate yield ratios are nearing expensive in the short end of the yield curve, fair in the intermediate part of the curve, and attractive in the long end of the curve.

The bottom line

As a result, we believe that tax-exempt municipal bonds may continue to be an integral part of taxable investors’ portfolios. The tax-exempt nature of the asset class positions it well to potentially produce a superior after-tax return compared to other investment grade fixed income sectors.

David Jurca is a research analyst, global fixed income, for Russell Investments

1 Source: AllianceBernstein

2 Source: Wells Capital Management

3 Source: ICI, 2014.

*Though certainly not always the case. In last summer’s ‘taper tantrum’ rate rise, municipal rates actually rose faster than investment grade corporate rates. However we believe this was technically driven (and now the ratios have reverted back to normal). There also tends to be more callable bonds in the municipal sector, and those bonds tend to be more sensitive to interest rate movements.

The Barclays Municipal Bond Index is an index, with income reinvested, representative of the tax-exempt municipal bond market with a maturity of at least one year.

Barclays U.S. Corporate Investment Grade Index: Dollar denominated, investment grade, publicly issued securities with a minimum final maturity of at least one year, issued by both corporate and non corporate issuers.

Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (“junk”) bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages. Investment in non-U.S. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries.

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