"The market's not a very accommodating machine; it won't provide high returns just because you need them." – Peter Bernstein
The low yield environment has investors scrambling for return opportunities, from social media stocks to junk bonds. One area where the baby was thrown out with the bath water is municipal bonds. As interest rates rose, bond prices fell. Investors bailed from any form of yield instrument, including municipal bonds.
Arguably though, with above average valuations for equities and high spreads to corporate bonds, municipal bonds seem like a compelling destination for capital. This is especially true considering today's highest effective marginal tax rate of 44.3%, which is the sum of the 39.6% Federal income tax, 3.8% net investment tax, and 0.9% Medicare surtax.
The Barclays High Yield Municipal index yields approximately 7%, which results in a taxable equivalent yield above 12%. Relative to corporate high yields this seems quite attractive. In addition, Moody's found the cumulative default rate from 1970 – 2012 for below investment grade municipals (which makes up the high yield index) was 2.56% versus corporate high yield at 13.87%. So that means there is a higher return expectation and lower default risk with municipal high yield versus corporate high yield.
Outflows in 2013 were a record with investors withdrawing $58 billion from tax-free bond funds. This even beat out the $44 billion withdrawn in late 2010 and early 2011, after Meredith Whitney made her foolish municipal market call on 60 Minutes regarding defaults.
Source: Investment Company Institute, Aurum
Investors found plenty of reasons to sell but it seems a reprieve from redemptions is finally here. A few headlines are here to stay and some may be transitory. Typically cited risks for municipal allocations include:
- End of Quantitative Easing and thus an interest rate rise
- Possibility of tax law changing status of tax-exempt municipal income
- Increasing credit risk due to pension liabilities and high profile distressed issuers such as Detroit and Puerto Rico
The Fed ending Large Scale Asset Purchases (also referred to as Quantitative Easing, QE) and resulting in a rise of interest rates is a risk across fixed income. Since the 'taper' was officially announced in December though, interest rates fell across the curve. Municipal yield spikes in the past have been bought relatively quickly. The white line below explains 80% of the municipal yield changes over the last 25 years. While interest rates could continue the ascent as inflation pressure builds, some of this seems to be in the price.
Source: St. Louis Fed
The political risk of taxing municipal income is heating up, especially with the swelling income inequality discussion and members of Congress looking at tax code changes. However, the political strategists we follow do not believe Congress would actually go through with changing such as an important aspect of the code after the last overhaul.
Finally, while credit risk is always a threat, municipals historically have much lower default rates across the credit spectrum versus corporate bonds.
A closer look at tax-free income is worth the time today given the paltry yield environment in fixed income.
For more information, please contact Aurum Wealth Management Group at 440-605-1900 or visit our website at aurumwealth.com. Stay up to date – follow us on Twitter @aurumwealth and to receive weekly investment-related updates, sign up for our free newsletter.
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