Municipal bonds have long been thought of as the province of institutions and wealthy, high-tax-bracket investors. For those in lower tax brackets, the yields just didn’t make sense on an after-tax basis.
But after the muni meltdown of the past four months, the asset class has suddenly become attractive for a wider range of investors — an overlooked factor that could help put a floor under this beleaguered market.
The drivers of municipals’ downturn have been twofold. First, while rising rates have taken the entire bond market out to the woodshed, munis have been hit particularly hard. Second, the high-profile Detroit bankruptcy — with all of the negative headlines that came with it — has spooked a market that tends to be populated by conservative investors.
These developments have fueled a stampede out of munis: last week, in fact, marked the 15th consecutive week that municipal bond funds have suffered outflows. These outflows have only exacerbated the pressure on an already-shaky market.
The resulting numbers speak for themselves. Since April 30, the iShares National AMT-Free Muni Bond ETF (MUB) has been hit for a loss of 8.3%, while Market Vectors High Yield Municipal Index ETF (HYD) has cratered 14.6%.
One important outcome of this downturn is that munis are now offering insanely attractive after-tax yields. Currently, MUB has an SEC yield of 3%, while HYD offers a yield of 6%. Consider that iShares 7-10 Year Treasury Bond ETF (IEF), which has a comparable average maturity to MUB, is yielding 2.42% — meaning that MUB has a superior yield even before tax considerations are taken into account. Similarly, the 6% on HYD is superior to the 5.57% yield investors receive from the iShares iBoxx $ High Yield Corporate Bond ETF (HYG).
Keep in mind, these yield comparisons measure municipal bonds on a pre-tax basis. On an after-tax basis, the payouts become even more compelling:
|Federal Tax Bracket||MUB After-Tax Yield||HYD After-Tax Yield|
The numbers to focus on here aren’t the after-tax yields for those in the 33% and 39.6% brackets. It’s safe to say that for this cohort, the benefits of municipal bonds are already well-known.
Instead, the point of interest should be the yields that are now available to those in the 25% and 28% brackets. Notably, an investor in the 28% bracket could achieve a 5% after-tax yield with an 80%-20% allocation to MUB and HYD, respectively. Looked at another way, a 66/34 allocation to the two funds will earn a yield equal to that of HYG, but with substantially less credit risk.
This graphic from the Washington Post shows the large number of taxpayers in these brackets relative to those in the 33% and 39.6% range. With yields where they are, this group represents the source of a potentially massive influx of new buyers for municipal bonds. Even if just a small percentage of the 25%-28% cohort switches to munis from taxable bonds, the incremental buying power will be enormous.
Another reason to like municipal bonds here is that the asset class has a history of rebounding from headline-driven selloffs. As outlined in this article, investors were well-rewarded for going against the grain and buying munis following the Orange County debacle of 1994, the financial crisis of 2008, and the Meredith Whitney scare of 2010.
Keep in mind that the case for munis is largely long-term in nature. In the near-term, the asset class remains vulnerable to a sustained move in 10-year Treasury yields above the 3% level. While the odds of that have gone down following last week’s soft jobs report, investors need to tread carefully as long as the 10-year is knocking on the door of the 3% mark. In addition, uncertainty regarding Puerto Rico’s tenuous finances is likely to keep investors on edge.
The Bottom Line
Municipal bonds might not bounce back tomorrow, but after several months of poor returns — and yields that are becoming increasingly attractive for a new class of investors — the long-term opportunity is extremely compelling.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.