Municipal bonds are a bit of magic bullet in the investment world:
- Low risk
- Income producing
- Tax Free
Due to the tax-free feature, municipal bonds can be a great addition to a portfolio for high income earners or retirees that have high passive income (like rental properties). So how should you value municipals and decide if they are right for your portfolio?
Municipal bonds are typically considered a substitute for Treasuries in a portfolio. The US is exceptionally wealthy, the federal government has significant taxing authority and has control over the money supply, as a result Treasuries are considered a risk-free investment. Municipals on the other hand are not entirely risk free (as recent experience has demonstrated) but investment grade issuers have very low instances of default.
Understanding Muni Bond Ratings
As a brief aside on muni bond ratings:
- AAA-BBB = Investment Grade (IG)
- BB & B = Speculative Grade
- CCC-C = Junk (or perhaps more fashionably high-yield)
- D is considered in Default.
Below is a transition matrix from a 2018 study by S&P examining 30 years of muni defaults1. The matrix shows the probability that a bond of a certain rating “transitions” to a different rating over the course of a year. For example, the probability that a BBB rated bond is upgraded to A in a given year is 5.51%.
Looking at the above matrix we see that the probability that an investment grade (IG) bond (AAA-BBB) goes into Default (i.e. ‘D’ rating) in a given year is basically 0. The lower rated IG issuances (A and BBB) might change rating more often, but the probability that they miss payments and enter Default is very, very low so the comparison to Treasuries is justifiable.
US Treasury bonds make up about 40% of the taxable issuance in the United States so having a healthy allocation to municipals in the taxable portion of a portfolio (not IRAs, Roths, etc.) is often prudent for the high-income earner.
Basic Muni Bond Taxation
The primary motivator for holding munis should be your income tax rate. Because the income is tax-free, the yield on munis is (usually) lower than a Treasury bond of a similar maturity. Because the yield is lower, munis are evaluated based on their taxable-equivalent yield. You can apply a simple formula to calculate the taxable equivalent yield of a muni:
Taxable Equivalent Yield = Municipal Yield / (1-Tax Rate)
Or equivalently
Tax-free Yield = Taxable Yield * (1-Tax Rate)
The general rule for taxation of government bonds is that the issuer can tax the income. For Treasuries, which are issued by the federal government, the IRS retains the right to tax the income, but states cannot tax Treasury income. Likewise, for munis, issued by states and localities, the income is tax free at the federal level, but states retain the right to tax. There is a very important catch though, if you purchase the municipal bonds from the state in which you live then the income is also treated as tax free at the state-level; this is known as double tax free and can make a major impact to the return on your bonds.
Many states and cities that have high income tax rates are heavy issuers of municipal bonds with the intention of attracting investment in the state. The below map from the Municipal Securities Rulemaking Board2 (MSRB…also a very boring name) shows the 2018 issuance in billions of dollars by state.
You can see that the 3 most populous states (New York, California, and Texas) account for about $150B in muni issuance annually. We also see states like Colorado, Florida and Pennsylvania amongst the top issuers so if you live in one of these states then you might want to seriously consider adding munis to your portfolio to reap that double tax-free income.
Real World Example
Let’s run through a quick example with an actual bond from my home state of Colorado and calculate the taxable equivalent yield and see how it stacks up to a Treasury.
On 4-17-20, a muni bond from Colorado’s Regional Transportation District (RDT), our state’s glorious and totally flawless transportation system, had a AA bond maturing on 10/31/2025 with a yield of 1.326%. For comparison, an equivalent 5-year Treasury had a yield of 35 bps (.35%). So even before adjusting for taxes the RDT bond had a yield almost 4 times higher than the Treasury. Let’s suppose your annual household earnings are $200,000, if you’re married then your joint federal tax rate is 22%. Colorado has a flat state income tax rate of 4.63% on all earners. So, adding these up, your all in tax rate is 26.63%.
Let’s then apply the formula for taxable equivalent yield from above:
Taxable Equivalent Yield = .01326 / (1-.2663)
= 1.80%
So, having accounted for taxes, the yield that you would need to receive on a Treasury would need to be about 1.80% before you would prefer to invest in the Treasury v. the muni bond. That’s an exceptional difference and the difference will be even larger if you have a very high income. For example, if your family is in the top federal tax bracket of 37.5% and you add in the Colorado tax rate of 4.63% then your taxable equivalent yield increases to 2.3%!
A Quick Caveat
It’s worthwhile to point out that the current conditions of the muni bond market are unique. COVID has sparked concern that municipalities across the board might struggle to make payments and as such the implied risk of default is much higher than it would be under “normal” circumstances (like 2 months ago). Consequently, the yield premium of munis over Treasuries is substantially higher than the historical average. Going forward we would not anticipate the taxable equivalent yield of our RDT bond to be some 5 to 6 times greater than an equivalent Treasury. By this measure, munis look like an extremely good buy right now with the prospect for significant future yield compression as conditions normalize.
Regardless of the condition of muni market right now the concepts of taxable equivalent yield and portfolio positioning that I introduced still apply. So, take some time to look at your income and portfolio and see if munis are a good fit for you.
Thanks for reading!
Aric Lux.
Sources:
1. S&P 2017 Annual U.S. Public Finance Default Study And Rating Transitions
2. MSRB Muni Facts
