An often “overlooked” corner of the municipal bond market – taxable munis – is drawing a lot of attention from fixed-income investors.
Actually, “overlooked” is a misnomer. Though they’re prominent now in headlines and among some financial professionals, we’ve been recommending taxable munis for our clients’ retirement accounts for decades.
Today, the spotlight is a little brighter on these bonds for two main reasons: attractive yields and increased availability.
Unlike their tax-exempt brethren, income from taxable munis is subject to federal and often state and local taxes. But it’s their yields that are turning heads: 0.5 percentage points to 1.5 percentage points higher than similarly rated corporate debt, according to Barron’s.
What’s more, they enjoy a historically lower default rate compared with corporates.
Spike in supply of taxable munis
In addition to a yield advantage, taxable munis have drawn increased attention because of the sharp growth in supply.
So far this year, more than $170 billion of taxable munis have been issued, twice the $85 billion sold last year. In total, the taxable market has swelled to about $700 billion, though it’s still dwarfed by the $3.8 trillion in tax-frees.
Analysts say the root of the issuance spike is the 2017 tax overhaul, which removed the tax-free nature of advance refunding bonds.
Advance refunding bonds enable issuers to replace older, higher-interest rate bonds with new, lower-interest rate bonds. From 2012 to 2017, more than $475 billion advance refunding bonds were issued, saving taxpayers an estimated $14 billion.
We disagreed with the move, as did a cross-section of government financial officers (“Restore Advance Refunding Bonds, Break Gridlock”). Tax-free advance refunding bonds make sense for both issuers and investors.
Nevertheless, the law meant refundings would be taxable and we’ve seen the results: About 60% of taxable muni debt this year has been related to refinancing.
An attractive option
For many investors, taxable munis make sense, especially in a retirement account.
Yields can range from 1.5% to 5.00% on individual bonds, a significant advantage depending on the investor’s tax bracket, and they yield more than corporates and Treasuries in all tax brackets.
But the spike in issuance may not last if, for example, the 2017 tax law is revised to restore tax-free advance refundings or if interest rates change.
For now, though, investors seeking the relative safety and dependability of munis with attractive yields have appealing options.
As with tax-free bonds, the goal with taxable munis is simple: Keep your interest clock ticking.