Tax Free Municipal Bonds Look Attractive

By Portfolio Managers – Kevin Strauss & Kevin Kelly

Interest rates have broadly increased over the past few years, making tax-free municipal bond yields more attractive for those in high federal tax brackets, and, even more so, for those living in states with high state income tax rates. Three years ago, intermediate A- rated municipal bond yields were approximately 0.5%, while today they are in a range of 3.25% – 3.50%. For someone in the highest federal tax bracket and living in a high-income tax state, the equivalent yield on a taxable bond or “tax equivalent yield,” would be 7% or higher, a yield that is considerably above alternative high quality, investment-grade fixed income securities. As a reminder, the highest federal tax bracket is 37%. Interest from other fixed income instruments is also subject to a 3.8% Net Interest Income (NII) tax, which brings the total federal tax rate to 40.8%. Add to that 9% (or greater) state income tax rates in a number of states and many investors are paying a marginal tax rate of 50% or higher on taxable bonds. Even for those living in states with no state income taxes, the tax equivalent yield of intermediate maturity municipal bonds today is likely greater than 5.75% for anyone in the highest federal tax bracket.

On a relative value basis, yields on A-rated municipal bonds have traded in a range of 60% – 80% of US Treasury yields over the past four years. Very recently, however, municipal bond yields have risen to approximately 75% of Treasury yields. Note that this ratio can be volatile and today’s yields are offering investors an unusual opportunity. Unlike Treasuries, CD’s, and money market funds, tax free municipal bonds are often challenging for retail investors to purchase because there are tens of thousands of issuers and hundreds of thousands of individual issues of municipal bonds. Municipal bonds also differ by funding sources, duration, call provisions, and other details. Munis may be tax-free, but they are not free of complexity. It is important to understand what you own, when it may be called away, what the tax implications are, etc. Retail investors are also often limited to the inventory available from their broker/dealer.

Our approach to selecting municipal bonds for clients brings together deep analysis of the available securities, examines both absolute and relative value, considers risks and bond provisions, and leverages our capability for sourcing bonds through our trading desk. At ACM, we have found it beneficial for clients to own individual securities as it allows the ability to hold bonds to maturity, if desired. This stands in contrast to the alternatives available to most retail investors: owning municipal bond mutual funds or ETF’s, which expose investors to increased volatility as fund managers are often forced to sell bonds at inopportune times which can result in unnecessary losses or taxable gains to investors of the fund or ETF. The ACM Muni Bond Strategy is customized to meet each client’s objectives. We can manage a state-specific portfolio in any state in the country, a national portfolio for those clients in states that have no state income tax or any blend of the two (with a state preference). We only invest in municipal bonds that have an underlying credit rating of A- or higher, regardless of insurance coverage. Many of the bonds in each portfolio are double-barreled, which means that they also have A-rated insurance on top of their own credit. We focus on general obligation bonds which are backed by the full faith and credit and taxing authority of each municipality and we invest in essential service revenue bonds such as power, electric, water, sewer and school district bonds. We avoid airports, healthcare facilities, housing developments, and sports and convention center bonds as these four areas have the highest historical default rates. This makes the ACM Municipal Bond Strategy among the highest quality and most conservative in the industry. Municipal bond management is also available at ACM as a fixed income allocation of a balanced portfolio, along with high quality equities. While ultra short bonds still have interest rates above 5% today, they could move lower more quickly than many expect. A focus on short term yields exposes investors to significant reinvestment risk, if rates decline. Investors today have an enticing opportunity to lock in attractive tax-free municipal bond yields in a portfolio with a duration of 3-4 years that results in tax-equivalent yields of approximately 6%-7% for those in high tax brackets. This allows investors to secure above average tax-free yields for a number of years without taking much credit or interest rate risk.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.