by Brad Houle, CFA
Principal
Head of Fixed Income
Portfolio Management
For investors seeking income and a source of portfolio stability, municipal bonds present a compelling option. These debt instruments are issued by cities, states and local governments across the United States to finance public projects such as schools, roads and utilities. A primary benefit of municipal bonds is that the income they pay is exempt from federal income taxes. Additionally, depending on the bond and the investor's location, the tax exemption can also apply at the state and local levels. This tax advantage is particularly beneficial for individuals in higher income tax brackets. Beyond the tax benefits, municipal bonds can also offer portfolio downside stability in risk-off environments.
To illustrate this tax advantage, let’s consider an investor residing in Multnomah County in Portland, Oregon, which has among the country’s highest state and local taxes. Using the assumed maximum federal rate of 37%, and a combined 15% for Oregon state, Multnomah County and metro local taxes, the investor’s total assumed tax rate would be 52%. For a municipal bond yielding 3.5%, the tax-equivalent yield is roughly 7.29%. This yield is the pre-tax yield an investor would need in order to net a 3.5% after-tax return. The tax equivalent yield represents the pre-tax return a taxable bond would need to offer to match the after-tax return of a tax-exempt bond.
It is our view that the current market environment suggests a good entry point for investing in municipal bonds. Municipal bond performance recently lagged U.S. Treasury bonds significantly, making valuations extremely attractive. On average, municipal bonds are priced to yield about 75% of what treasury bonds yield, along with the fact that the interest on municipal bonds is tax-exempt, it makes sense that municipal bonds should have lower yields than treasury bonds. However, with the recent volatility in the market, longer-term municipal bonds trade at closer to 95% of U.S. Treasury bonds, a historic high. This disruption in the municipal bond market is due to the elevated supply of bonds, investors selling municipal bonds to pay taxes and investors selling bonds to meet margin calls when the stock market hit a recent rough patch. There has also been speculation that the current administration wants to disallow the tax exemption for municipal bonds. We don’t believe this will occur because tax exemptions are crucial for state and local governments to lower their interest costs. In short, municipal bonds offer compelling value for a low-risk investment from the standpoint of default risk. This disruption has been created by technical factors and supply and demand imbalances rather than concerns about credit quality.
This week, the Federal Reserve Open Market Committee voted unanimously to maintain the benchmark interest rate, acknowledging increased uncertainty in the economic outlook and rising risks for unemployment and inflation. Chair Jerome Powell emphasized that the Fed is not hurrying to cut rates and dismissed any influence from political pressure. Despite a weak first-quarter GDP, Powell expressed optimism about revisions and described the labor market as healthy while noting that inflation remains above target but is moving sideways.
Takeaways for the Week
Municipal bonds may offer a compelling opportunity for individual investors in high tax brackets in today’s market
The disruption in the municipal bond market is largely supply/demand driven, while credit quality remains largely robust in this market