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Recently enacted higher tax rates — and the threat of even higher rates — enhance the attractiveness of tax-exempt income, especially versus other income-producing securities.
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Lower quality, shorter maturity investment-grade municipal bonds may provide similar yields as longer maturity bonds, but with lower interest-rate risk and volatility.
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Independent and well-resourced credit research is a critical tool in lower-quality municipal bond investing.
Among fixed-income and equity asset classes, municipal bonds have proven resilient and reliable investments over the long term. Risk-adjusted performance — strong returns with relatively low volatility — and the attractive risk/return profile of municipal bonds have been very appealing versus other asset classes.
What you keep after taxes is what matters
Returns of municipal bonds have been magnified by the benefit of their tax-exempt status, most recently by the increase of the highest federal tax rate from 35% to 43.4%.3 In this tax environment, an after-tax yield of 4.10% equates to an approximately 7.25% taxable-equivalent (i.e., pre-tax*) yield. Potentially higher taxes — federal and state — make investments exempt from income taxes more attractive.
Credit research is key
Independent and well-resourced credit research allows investment professionals to invest in lower quality securities — an area in which individual investors may not have the necessary resources to comfortably invest in — to uncover higher yielding, shorter maturity bonds that are less sensitive to changes in interest rates than longer, higher quality bonds.
To earn an approximately 4.10% after-tax (7.25% pretax*) yield, a municipal bond investor may invest in a/an:
- BBB rated 10-year bond
- A rated 13-year bond
- AA rated 19-year bond
- AAA rated 30-year bond
Although the state budget environment generally continues to improve, local governments are expected to continue to face financial headwinds Rigorous analysis, including direct discussions with issuers, is key to successful investing in this space.
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* Assumes 2013 federal income tax rates of 35% and 43.4% (39.6% income tax rate + 3.8% net investment income tax rate). Other taxes are possible. The effect of potential federal income tax phase-outs of personal exemptions and itemized deductions is excluded from this schedule. Had they been included, the reported tax rate would have been higher, which would then increase the municipal taxable-equivalent yield for any given municipal stated yield. State income taxes may be applicable and can further reduce the after-tax returns of some municipal bond investments (depending on the state of residence). Income from certain tax-exempt securities may be subject to the federal and/or state alternative minimum tax for some investors. In addition, federal and state income tax rules will apply to any capital gain distributions and capital gains or losses on sales. When investing in municipal securities, investors in higher tax brackets can receive a greater tax benefit than those in lower tax brackets. Municipal bonds provide income exempt from federal and, in some cases, state income taxes.
There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.