The municipal bond is one of the most popular tax-efficient investments you could make because its interest payments are exempt from federal, state and local taxes. As a result, the tax equivalent yield of a muni is higher than its current yield and usually higher than the yields of many others types of bonds, including Treasuries and corporates.
The tax equivalent yield of a 20-year muni yielding 3.5%, for example, is almost 5.8% for investors in the top federal tax bracket of 39.6% (couples with taxable income over $450,000) and even higher after state and local income taxes are included in the calculation, if there are any.
But Andy Chorlton, head of U.S. multi-sector fixed income at Schroders, tells ThinkAdvisor that munis don’t necessarily deliver the best after-tax return, which is what investors really want.
“There are times when munis do not provide the best after-tax return,” says Chorlton. “Sometimes it’s Treasuries and sometimes it’s corporates that deliver that.”
And according to Chorlton, that sometime is now. Many municipal bonds are currently more expensive than corporates on an after-tax basis following strong gains last year when munis were the best performing U.S. bond sector in 2016.
A 10-year AAA muni is yielding 1.84%, according to Bloomberg’s 10-year muni benchmark, slightly less than the 1.9% yield on the 10-year Treasury note and about half the yield of a 7-year AAA corporate bond, which has a comparable duration, or sensitivity to changing interest rates. In addition, corporate bonds, which have underperformed in the last 18 months unlike munis, have a “greater chance of principal gain,” says Chorlton.
“Sometimes it’s worth paying tax on coupons,” says Chorlton. “The goal for investors should be the best after-tax return, not maximum tax efficiency.”