Compelling opportunity in municipal bonds

Catherine Stienstra, Senior Portfolio Manager | November 7, 2013

  • Municipal bond market movements have provided an attractive opportunity to lock in attractive yields.
  • Although credit problems in Detroit and Puerto Rico made headlines, these issues are not representative of the broad municipal market — the number of municipal defaults is at its lowest level since at least 2009.
  • With rising tax rates, the advantages of tax-exempt income can be considerable.

Attractive yields vs. corporate and Treasury bonds, a historically steep yield curve, defaults at their lowest level since 2009, increasing tax revenues and high income tax rates make municipal bonds a compelling investment opportunity.

  • Third quarter 2013 was a roller coaster for the municipal bond market, as it declined 0.19% — its second consecutive quarterly loss (as measured by the Barclays Municipal Bond Index). July and August were negative due to sharply higher interest rates that resulted from confusion over Fed policy and heightened concerns about Detroit and Puerto Rico. The yield curve steepened, as rates on longer maturity bonds increased more than on shorter bonds. In addition, mutual fund redemptions hit record levels, further pressuring bond prices. September reversed course, increasing 2.15%, as market fears faded, issuance slowed further and investors took advantage of opportunities to lock in especially attractive interest rates.
  • Spreads widened in lower quality and high-yield securities, as Detroit, Puerto Rico and Illinois pension problems crowded the headlines. Headlines aside, these issues are not representative of the broad municipal market, and the number of municipal defaults is at its lowest level since at least 2009.
  • Municipal fundamentals continue to improve on the back of increasing sales, income and property taxes.

Market movement provides an attractive opportunity to lock in attractive yields

  • Depending on credit quality and maturity, municipal bond investors today may be able to earn taxable-equivalent yields above 8%, far higher than yields provided by Treasuries or corporate bonds.* The yield curve is steeper than historical averages, allowing for yield pick-up on intermediate- and long-maturity bonds. Municipal/Treasury yield ratios indicate municipal bonds are cheaper vs. Treasuries on a relative basis.
  • Municipal bonds are one of the remaining investments that allow investors to shelter their income from taxes. With the highest federal tax rate at 43.4%, plus state taxes, the savings provided by municipal bonds can be considerable. It is what you keep that is important.

Muni vs Corp Yield

Sources: Thomson Municipal Market Data (MMD), Bloomberg BVAL, 09/30/13

**Assumes 2013 federal income tax rate 43.4% (39.6% income tax rate + 3.8% net investment income tax rate). Other taxes are possible. The effect of potential federal income tax phase-outs of personal exemptions and itemized deductions is excluded from this schedule. Had they been included, the reported tax rate would have been higher, which would then increase the municipal taxable equivalent yield for any given municipal stated yield. State income taxes may be applicable and can further reduce the after-tax returns of some municipal bond investments (depending on the state of residence). Income from certain tax-exempt securities may be subject to the federal and/or state alternative minimum tax for some investors. In addition, federal and state income tax rules will apply to any capital gain distributions and capital gains or losses on sales. When investing in municipal securities, investors in higher tax brackets can receive a greater tax benefit than those in lower tax brackets. Municipal bonds provide income exempt from federal and, in some cases, state income taxes.

Past performance does not guarantee future results.

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*Source: Thomson Municipal Market Data (MMD)

Indices are not managed and do not incur fees or expenses. It is not possible to invest directly in an index.

The Barclays Municipal Bond Index is an unmanaged index considered representative of the tax-exempt bond market.

There are risks associated with fixed income investments, including credit risk, market risk, interest rate risk and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities. Income from tax-exempt municipal bonds or municipal bond funds may be subject to state and local taxes, and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal income tax rules will apply to any capital gains. There are risks associated with an investment in bond investments, including the impact of interest rates, credit, and inflation. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Non-investment grade securities, commonly called “high-yield” or “junk” bonds, have more volatile prices and carry more risk to principal and income than investment grade securities.