Municipal bonds that aren’t tax-exempt?

For many investors, taxable municipal bonds are counterintuitive: What’s the point of investing in municipal bonds if the interest income is subject to federal and state taxes?

The answer lies in their compelling yields – and the generally strong credit quality associated with the municipal bond market.

It’s no wonder, then, that often-overlooked taxables are drawing renewed attention from fixed-income investors this year.

Many of the same issuers

Taxable munis are issued by many of the same state and local governments and public authorities that issue tax-exempt bonds. They may finance projects that do not qualify for federal tax exemption or be issued as taxable securities for other financing reasons.

In exchange for giving up the federal tax exemption, investors get higher yields than they would from comparable tax-exempt bonds. Taxable munis can also offer attractive yields compared with other taxable investments, including investment-grade corporate bonds.

Higher yields than similarly rated corporate debt

“Taxable municipals continue to serve as a diversified source of high-grade income within multi-asset portfolios,” New York Life Investments said in a mid-year report, citing “strong” credit quality and consistent investor interest as factors supporting the market.

Nuveen recently highlighted several reasons taxable municipal bonds compare favorably with corporate debt. Municipal issuers are not subject to risks such as leveraged buyouts and corporate mergers. Nuveen also noted that AA and A-rated taxable munis currently offer higher yields than similarly rated corporate bonds, while municipal bonds historically have experienced lower default rates and higher recoveries during periods of stress, based on Moody’s data.

Municipal issuers have other advantages as well. Many finance essential services supported by reliable revenue streams, while governments and public authorities have tools such as rate adjustments, reserves and, in some cases, state support to help manage financial pressures.

More choice

That does not diminish the appeal of traditional tax-exempt municipal bonds. In fact, municipal yields remain near their highest levels of the past decade, and currently enjoy broadly stable credit fundamentals and solid demand from investors seeking tax-exempt income (“After the Latest Tax-Exemption Threat”).

Instead, taxable munis expand the choices available to fixed-income investors.

They may be particularly useful in tax-advantaged accounts, such as IRAs, where the tax exemption of traditional municipal bonds provides no additional tax benefit.

They also merit consideration when comparing taxable fixed-income alternatives and find a municipal bond with an attractive yield relative to its credit quality and maturity.

For buy-and-hold investors, the objective isn’t accurately predicting where bonds prices or interest rates go next. It’s identifying bonds with appropriate credit quality and maturities and lock in an income stream that meets their needs.

Tax-free or taxable, municipal bonds provide investors with different options to pursue that goal.