Get tax-exempt income on the cheap as bond shake-up hits munis

Published Thu, Oct 12 20232:51 PM EDTUpdated Thu, Oct 12 20235:08 PM EDT

Tax-exempt income and relative safety are on sale for investors who are sniffing around municipal bonds. Intensifying fears around a "higher for longer" interest rate policy from the Federal Reserve reached a fever pitch last week as Treasury yields spiked and a sell-off in equities and bonds ensued. Even the safest corners of the bond market weren't spared as the iShares National Muni Bond ETF (MUB) slumped on Oct. 6 to its lowest level since March 2020. MUB YTD line MUB's year to date performance But a sudden decline in prices shouldn't frighten away investors from what could be a great buying opportunity. "My view is that there is no rubble in munis; we had some rate volatility, but it's just that," said Nathan Will, head of muni credit research at Vanguard. "This is a high-quality asset class with eye-popping yields right now." He added that AAA-rated municipal bonds — the highest in credit quality — can offer yields of up to 5% on a tax equivalent basis. Will added that the municipalities themselves have held up well with "balance sheets as strong as they have been in a long time." Investors seem to be swooping in even amid this latest bout of volatility. MUB attracted $386.5 million in new money over the past week — and has garnered nearly $3.9 billion in flows year to date, per FactSet. The Vanguard Tax-Exempt Bond ETF (VTEB) also brought in $312.6 million in the past week, and it's picked up close to $3.7 billion in flows in 2023, according to FactSet. Tax-exempt income Interest income from municipal bonds is exempt from federal income tax — and can avoid state and local levies, too, if an investor and the bond issuer are in the same jurisdiction. This feature makes munis especially attractive to high-income investors in the 32% marginal federal income tax bracket and higher. Investors weighing a tax-exempt municipal bond against a corporate bond would do well to check out the tax equivalent yield. This calculation shows you the yield you'd have to earn on a taxable bond to get a comparable amount of income from a muni. An analysis by New York Life Investments found that if a taxpayer in the 32% tax bracket picks up a muni with a tax-free yield of 5%, a taxable investment would have to yield 7.35% to provide comparable income. "Investors don't need to take the risk they needed to in the past to get attractive yield," said Cooper Howard, fixed income strategist at the Schwab Center for Financial Research. Munis can also bring a bit of tax complexity, as well. Investors should keep them in taxable accounts, since the income they pay is tax-free. But they should also know that if they buy individual issues too cheaply versus the bond's par value, there could be a surprise tax on the discount itself. If this discount is equal to or greater than 0.25% of par value, multiplied by the number of years until maturity, then it's taxed as ordinary income. That rate can run as high as 37%, based on your taxable income. Adding a little duration With the yield curve inverted — meaning short-dated issues offer higher yields than long-dated bonds — investors have been hiding out in cash, money market funds and Treasury bills. The problem is that a heavy concentration in short-dated fixed income exposes investors to reinvestment risk when interest rates decline, leaving them with limited options to pick up additional yield. Municipal bonds could be a way to add some duration to lock in those higher rates. Duration is a measure of a bond's price sensitivity to changing interest rates, and issues with longer maturities tend to have greater duration. Schwab's Howard noted that the 5- to 7-year part of the municipal bond curve is favorable. "The good thing is that the yields are attractive enough that with an incremental move out in duration you'll still get a reasonable tax equivalent yield and insulate yourself somewhat from this rate volatility," said Shannon Saccocia, chief investment officer of NB Private Wealth. She noted that taxes aren't likely to go down anytime soon, which makes municipal bonds even more of a bargain for investors seeking relatively safe income. "All those things point to 'if you thought munis were attractive earlier this year, they're even more attractive now,'" Saccocia added.