Municipals flashing “buy” signal

Chad Farrington, CFA, Head of Municipal Bond Research | July 8, 2013

  • The recent swift correction in tax-exempt interest rates has created opportunities for municipal bond investors to attain very attractive risk-adjusted returns.
  • An investor in the highest tax bracket could achieve around a 7.0% taxable equivalent yield in today’s market environment.
  • With credit quality largely remaining stable for many municipal issuers and rates significantly higher than just a few weeks ago, this may be a good time to lock in an attractive level of tax-exempt income at a good price.

The recent swift correction in tax-exempt interest rates has created opportunities for municipal bond investors to attain very attractive risk-adjusted returns. Investors in higher tax brackets will find the yields currently offered by municipal bonds quite appealing. Depending on an investor’s credit risk appetite, better than 7% taxable-equivalent yields* can be achieved without going too far out the yield curve.

In the table below, we outline where on the maturity curve an investor in the highest tax bracket could achieve around a 7.0% taxable equivalent yield in today’s market environment. For example, an ‘A’ rated bond maturing in 14 years offers around a 3.99% yield, or 7.05% on a taxable-equivalent basis – similar yield but with much less duration than a 30-year ‘AAA” rated bond. It is important to note that adequate credit research capabilities are necessary to take advantage of lower-rated investment grade securities.

MuniChart_1

Although an improving economic environment is likely to lead to higher interest rates, we believe relatively lower rated credits should benefit most from a fundamental credit standpoint. Relatively higher coupons and wider credits spreads provide some cushion for lower-rated bonds in a rising rate environment. With the help of independent credit research, an investor could lock in approximately 4% yields, or better than 7.0% on a taxable-equivalent basis, by buying a BBB bond maturing in ten years with relatively less interest rate risk.

Redemptions out of mutual funds partly caused the recent sell-off and may likely continue as investors open quarterly statements revealing potentially disappointing second quarter results. However, favorable supply conditions over the coming months and tax-exempt rates in excess of taxable U.S. Treasury rates should provide support to the municipal bond market. With credit quality largely remaining stable for many municipal issuers and rates significantly higher than just a few weeks ago, this may be a good time to lock in an attractive level of tax-exempt income at a good price.

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* Assumes a 2013 federal income tax rate of 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.

There are risks associated with fixed income investments, including credit 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.

Chad Farrington

CFA, Head of Municipal Bond Research
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