This safe investment is beating today’s record-high returns on government bonds
It’s been a wild ride for bond investors in recent months.
The benchmark 10-year Treasury yield has shot up a full percent in the last year to hit a 15-year high of 4.42% in August. Former Treasury Secretary Larry Summers expects it to average 4.75% going forward.
For investors seeking a decent yield on a safe investment, that sounds hard to beat.
Or is it?
Government bonds vs. tax-equivalent muni bonds
For investors, especially those in high-tax jurisdictions like California and New York State, municipal bonds look like a better bet. That’s because tax-free municipal bonds are currently delivering more money to investors’ after-tax bottom lines.
Muni bonds’ after-tax advantage is nothing to sneeze at.
According to Raymond James, investors can get a full percentage point more return on a 10-year investment, and over 2 percentage points more on a 20-year investment, if they choose muni bonds over Treasuries.
At first glance, that doesn’t make sense. Here’s how the market is supposed to work:
- Assume that an investor pays 20% tax on the interest income from their taxable bonds.
- A 10-year AA-rated (taxable) Treasury bond yields 5%.
- A 10-year AA-rated (tax-free) muni bond yields 4%.
- The after-tax return on the Treasury is 5% x .80, or 4% — equivalent to the muni bond’s yield.
If the relationship gets out of whack, canny Wall Street traders should swoop in and buy the overpriced bond, putting the two markets back in equilibrium.
But that’s not always happening.
In some cases, a municipal bond’s “tax-equivalent yield”—the yield that takes into account the additional money investors keep by not paying taxes—is higher than the otherwise identical Treasury bond’s yield.
There are different tax-equivalent yields for investors with different marginal tax rates. The higher the investor’s marginal tax rate, the bigger benefit the investor gets from the muni tax shield.
The Federal government exempts all munis from taxes, but states and local jurisdictions have their own rules, so investors need to understand what their tax situation is to calculate their tax-equivalent yield. Briefly, the equation this is:
Tax Equivalent Yield = Tax-Free Yield / (1 – Tax Rate)
On average, muni returns look outstanding. According to Raymond James, as of August 21:
- A 10-year AA rated municipal bond with a yield of 3.11% has a tax-equivalent yield of 5.25% vs. a Treasury yield of 4.25%.
- A 20-year AA rated municipal bond with a yield of 3.93% has a tax-equivalent yield of 6.63% vs. a Treasury yield of 4.59%.
In fact, as this graph shows, muni tax-equivalent yields are higher than Treasury yields at every maturity. The black line shows the muni tax equivalent yields, and the red line shows Treasury yields.
The tax debate
There is a lot of debate about why munis have this tax-equivalent return advantage.
Some believe it is due to the fractured and illiquid nature of this $3.9 trillion market, which keeps it inefficient by blocking institutional investors from making the sort of huge trades that would equalize taxable and tax-equivalent returns.
That inefficiency sometimes works to investors’ advantage, as it is doing today.
A secondary advantage of muni bonds is that the investor does not have to manage the logistics of paying the tax.
According the Wall Street Journal, many investors who have plowed money into money market funds, corporate bonds, and other taxable instruments have not adequately planned for the tax they will eventually have to pay.
“The same investment that left you with a tiny tax bill two years ago might now cost a lot of money at tax time. In nearly all cases, no tax is withheld, meaning many taxpayers will get a surprise tax bill next spring,” the Journal warned.
Investors do not seem to be getting the message
In the week ending August 17, total money market fund assets increased by $39.70 billion to $5.57 trillion, according to the Investment Company Institute. But tax-exempt money market funds decreased by $2.69 billion in the same period.
Tax-exempt muni bond funds saw outflows of $264 million that week, according to Refinitiv.
Potential muni investors should note that their capital gains are taxable—only the interest is tax-free. If investors buy a bond at 90 cents on the dollar, hold it to maturity and get the full 100 cents face value, they will owe taxes on that 10 cents of capital gains.
Also, an investor’s state of residence bears a lot on the muni bond’s advantages—for example, those issued in Texas or South Dakota, neither of which have state income tax, are less advantageous than those issued in New York or California, with their 10.9% and 13.3% state income taxes, respectively.
Both states tax out-of-state muni income, so residents of each of those states should only invest in bonds issued by entities within their home jurisdictions.
The muni boom is not an unlimited time offer
If the Fed stops raising rates and starts cutting, or if there is a shift from outflows to inflows into the muni market, it could push prices up and reduce yields.
That would be good for communities looking to finance construction of hospitals or schools, and for existing muni bond investors, but not so good for those who missed the boat.