Should Taxable Investors Still Rely on Municipal Bonds to Boost After-Tax Returns?
Yes. Municipal (muni) bonds have recently outperformed taxable equivalents before taxes and the tax advantage of high-quality munis has grown as interest rates have gone up. We recommend a neutral allocation to high-quality munis in taxable portfolios. Beyond the high-quality space, muni closed-end funds (CEFs) have the potential to deliver compelling after-tax returns.
The previous several years have been challenging for bond markets, with most major high-quality bond indexes experiencing their worst drawdown on record. US muni bonds—which have long been preferred by US taxable investors, given their tax advantage—have not been immune during the sell-off, but they have held up reasonably well versus taxable equivalents. Munis have outperformed Treasuries the past two years, and they are on track to do so again this year, generating an excess return of 3% per annum before taxes since the beginning of 2021.
Several factors have supported munis, including attractive starting valuations, strong credit fundamentals, and modest issuance. In addition, the after-tax yield advantage of investing in munis over Treasuries has grown as interest rates have risen. To illustrate this, consider a low-rate environment (December 2019) and a high-rate environment (September 2023). In December 2019, ten-year munis were yielding 1.6% and ten-year Treasuries were yielding 1.9% (1.1% after-tax yield), compared to 4.0% and 4.6% (2.7% after-tax yield), respectively, as of September 2023. While the ten-year muni/Treasury yield ratio was about 0.85 in both periods, the muni after-tax yield advantage has increased from around 50 basis points (bps) to 125 bps as yields have risen.
In our view, taxable investors should continue to rely on muni bonds in their policy portfolio as a strategic holding, given their tax advantage, and they should be neutral high-quality munis tactically versus Treasuries. This is because the yield differential between the two asset classes is not compelling even though credit fundamentals and supply technicals remain strong. Ten-year muni/Treasury yield ratios are reasonable at 0.86 (54th percentile), but they’ve fallen considerably from their early-2022 peak, suggesting there is limited upside from a further tightening in relative yields going forward. Further, the ratio could widen if the economy enters a recession—ten-year yield ratios averaged more than 300 bps in the last two recessions.
It is worth noting that ten-year muni/Treasury yield ratios never topped 1.0 during the higher rate environment prior to the 2008–09 Global Financial Crisis (GFC). Since the GFC, the same ratio has been more volatile, which is likely due in part to a rise in negative credit headlines and greater fund participation in the market. However, muni credit fundamentals remain strong and investor appetite for munis could increase as investors look to lock in the growing after-tax yield advantage offered by munis. Muni fund holdings declined by nearly 20% in 2022 amid record outflows, but outflows have stabilized in 2023 as the risk of additional Federal Reserve rate increases has declined. So, while we still anticipate wider muni/Treasury yield ratios in the event of a recession, the magnitude and length of any dislocation may be less pronounced than recent sell-offs.
Therefore, we recommend a neutral allocation to high-quality munis in taxable portfolios. Still, there are potential tactical opportunities developing in the muni CEF space. Many muni CEFs are more risky than vanilla munis, as they primarily invest in long-duration bonds and use leverage to boost their after-tax yield. As such, the sharp rise in interest rates and inverted yield curve have forced levered muni CEFs to cut distributions, causing discounts to widen. The average discount to net asset value within the $49 billion muni CEF universe is approximately -13.1%, which is near the widest level in nearly 23 years. While discounts could widen further on tax-loss selling into the year-end, history suggests muni CEFs have the potential to deliver compelling after-tax returns with discounts at current levels.
For implementation, we prefer muni CEF managers that can target higher-quality, lower-duration, less-levered bonds and can generate excess returns via targeted use of leverage, trading around discount volatility, and non-market drivers of tighter discounts.
TJ Scavone, Investment Director, Capital Markets Research