Chas Craig, BridgeTower Media Newswires
The primary attraction to municipal bonds for taxable investors (e.g., individuals’ brokerage accounts and corporations) is that the interest these bonds provide is typically exempt from federal income tax. Given the tax exemption, looking at historical absolute spreads to Treasury securities is not as useful in the case of municipal bonds as it is for the taxable bond segments. Dividing the nominal yield of the ICE BofA US Municipal Securities Index by 1 minus the highest prevailing marginal individual income tax rate returns a historical “tax equivalent” yield. For the past two decades the spread of this tax equivalent yield over the 10-year Treasury yield has been about 2%. It is now just 0.4%, down from roughly 1% this time last year.
So, as with other bond segments with credit risk, yield spreads are tight by historical standards. However, the ICE BofA Single-A US Corporate Index, arguably the most comparable index of taxable bonds from a credit risk perspective, is trading at about 60% of its long-term spread to comparable maturity Treasury securities, tight for sure, but not the razor thin margin seen in munis now compared to the historical norm. This single-A corporate index provides a yield of 2.1% now, up from 1.5% as of yearend 2020, while the muni index provides a tax equivalent yield of just 1.9%, slightly down from last year in an environment where yields, in general, have increased materially off a low base in 2021.
Tax rates seem more likely to go higher than lower in the near-term, so investor positioning in anticipation of this change explains a great deal of munis’ outperformance over the past year (YTD referenced muni and corporate indices have returned 1.7% and -1.4%, respectively) since higher marginal tax rates boost the attractiveness of muni bonds, all else equal. This bias higher is true for individual tax rates, particularly for high income households that are the primary muni purchasers, but it is also potentially important for corporate rates. While I have used the top individual rate to calculate tax equivalent yields here, corporations (mostly banks and insurance companies) make up roughly a third of municipal bond buyers historically. However, the highest individual marginal tax rate would need to move almost 7 percentage points higher for the tax equivalent municipal yield to match the referenced A-rated corporate index yield. While the situation is fluid, it appears that such a tax increase is on the very high end of what is politically feasible. Further, if such an increase does come to pass, it will likely only be for the very few individuals that make $10 million or more a year.
Bottom line, although municipal bonds are typically a sensible choice for a sizable portion of the bond segment of a portfolio where a substantial amount of the capital is held in taxable accounts, munis appear to have gotten so rich that non-top-marginal tax rate investors should at least evaluate whether their current approach still offers the best after-tax yield compared to comparable interest rate and credit risk taxable alternatives.
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
