Muni Bond Research: A Guide to Fixed Income and Tax-Advantaged Income

Muni bonds offer a unique combination of tax-advantaged income and relatively low risk, making them an attractive option for investors seeking to diversify their fixed income portfolios.

Muni bonds are issued by state and local governments to finance various public projects, such as infrastructure development and education initiatives.

The tax benefits of muni bonds are substantial, with investors potentially saving up to 40% on federal taxes alone, depending on their income level and tax bracket.

For example, if an investor in the 32% federal tax bracket earns $1,000 in interest from a muni bond, they would only have to pay $320 in taxes, leaving them with $680 in after-tax income.

Municipal bonds are issued by nonprofit organizations, private-sector corporations, and public entities to fund public projects like constructing schools, hospitals, and highways.

They can be used for a wide range of public projects, but the most common ones are for infrastructure, education, and healthcare.

Municipal bonds can be issued by any public entity, including cities, states, and even airports.

Municipal bonds are often referred to as muni bonds or munis, which is short for municipal bonds.

They're a type of debt obligation that requires the issuer to pay back the loan with interest.

Municipal bonds pay lower coupon (interest) rates compared to taxable bonds, but they offer a tax-free income for qualified residents.

This means that investors who hold municipal bonds in tax-advantaged accounts can avoid paying federal income tax on the interest earned.

Readers also liked: Pimco Muni Etf

The municipal bond market is a significant sector of the US economy, with over $3.9 trillion in outstanding bonds as of 2022.

Investors are attracted to muni bonds due to their tax-exempt status, which can result in higher after-tax yields compared to taxable bonds.

Muni bonds offer a stable source of income for investors, with a low default rate of 0.2% over the past five years.

The muni bond market is also influenced by interest rates, with a 1% change in rates resulting in a $40 billion shift in investor demand.

Discover more: Corporate Bonds Market

The municipal bond market is a significant player in the financial world, with a value of $4.1 trillion as of Q4 2023.

This massive market has an average credit rating of AA, the same as the U.S. federal government, which can be comforting for investors.

The median state rainy day fund balance has surged to 13% of general fund spending, thanks to COVID-era federal policies that saw the federal government borrow and distribute funds to citizens and municipalities.

These rainy day funds have been growing steadily since 2011, when they equaled just 1.8% of general fund spending.

The largest issuers of tax-exempt bonds, including California, New York, Texas, Illinois, Florida, Pennsylvania, and New Jersey, now have much larger rainy day fund balances than they did ten years ago.

You might enjoy: Blackrock Muniyield Fund Inc

Municipal bonds are available in a variety of terms, ranging from two to 30 years. This flexibility allows investors to choose a term length that suits their financial goals and risk tolerance.

For those with a shorter time horizon, two-year bonds might be a good option. Two-year bonds are often considered a low-risk investment, making them suitable for investors who want to preserve their capital.

Investors with a longer time horizon may prefer bonds with a 30-year term. This longer term can provide a higher potential return, but it also comes with a higher level of risk.

On a similar theme: Ishares Short Term National Muni Bond Etf

Currently, municipal bond yields are higher than cash yields. This is due to strong U.S. economic performance and expectations of a second Trump term stimulating growth and inflation.

In high tax states like New York and California, A-rated municipal bonds offer taxable-equivalent yields (TEYs) of nearly 7.0%. This is a significant advantage over cash, which typically offers lower returns.

The mean ten-year cumulative default rate for all investment grade municipals is only 0.10%. This low default rate makes municipal bonds a relatively safe investment option.

Here's a comparison of current fixed income yields and cash yields:

As interest rates are expected to fall, municipal yields are likely to follow. This makes now a good time to consider investing in municipal bonds.

The level of rates has a significant impact on the market, and right now, rates are higher than they've been in a long time. In 2022, the U.S. Federal Reserve began raising the federal funds target rate to combat inflation and slow economic growth.

This has led to higher rates across the board, including pre-global financial crisis levels. The federal funds target rate has continued to rise through July 2023, making it a higher-for-longer narrative.

Our current view is that taxes are likely going to stay where they are or possibly increase based on the federal deficit. This could make municipal bonds an attractive investment option, especially considering the yield generated by them.

With rates higher, the yield on municipal bonds will likely remain attractive, and as we've seen in the past, this can be a favorable time for investors. History indicates a good outlook for municipal bonds when the Fed takes action, such as in 2024.

Take a look at this: Current Muni Bond Yields

Default risk is low for municipal bonds compared with corporate bonds. However, revenue bonds are more vulnerable to changes in consumer tastes or general economic downturns than GO bonds.

A bond's market price fluctuates with changes in interest rates, declining when interest rates rise and rising when interest rates decline. This can affect the investor's income.

Municipal bonds with longer maturities are more susceptible to interest rate changes, causing greater changes in the investor's income.

Additional reading: Bonds and Mortgage Rates

Default risk is low for municipal bonds compared with corporate bonds.

However, revenue bonds are more vulnerable to changes in consumer tastes or general economic downturns than GO bonds.

A facility delivering water, treating sewage, or providing other fundamental services has more dependable revenue than a park's rentable shelter area.

Municipal bond prices fluctuate with changes in interest rates: they decline when interest rates rise and rise when interest rates decline.

A bond with a longer maturity is more susceptible to interest rate changes than a bond with a shorter maturity.

Many municipal bonds carry call provisions, allowing the issuer to redeem the bond prior to the maturity date.

Investors lose income from interest payments and face reinvesting in a bond with a lower return when a bond is called.

The majority of municipal bonds are illiquid, making it difficult for investors to sell them quickly.

Investors needing immediate cash often have to sell other securities instead.

Credit quality remains strong, thanks to better fiscal management post-global financial crisis. States and local municipalities have implemented more fiscally responsible policies, rebuilding trust with investors.

Since the global financial crisis, many states have built their reserves via growth in tax revenues and federal aid. This has helped them remain stable and financially healthy.

The pandemic-era funding has also had a positive impact on municipal bond issuers. Many local governments used the money responsibly to shore up important government-funded programs like state pensions and school systems.

The Bloomberg Municipal Bond Index shows that the long-term municipal bond index yield is above the 20-year average yield to worst. This suggests that investors are willing to accept lower yields in exchange for the perceived safety of municipal bonds.

Municipal bond issuers have seen balance sheet improvements due to pandemic-era funding. This puts them in better fiscal positions than before the pandemic.

Related reading: Vaneck Short High Yield Muni Etf

Municipal bonds offer a unique combination of stability and tax benefits, making them an attractive investment option for many. They have a low default rate, averaging only 0.10% over the last 10 years, according to Bloomberg Finance L.P. and J.P. Morgan.

One of the key benefits of municipal bonds is their tax-exempt status, which can result in higher after-tax yield potential. In fact, taxable bonds may have a higher pretax yield than a muni bond, but investors should consider the tax obligations of that bond before making a comparison.

Consider reading: Bond Equivalent Yield

Tax-exempt municipal bonds can offer attractive yields, especially in high-tax states like New York and California, where A-rated municipal bonds offer taxable-equivalent yields of nearly 7.0%. This is a significant advantage for investors who are looking to minimize their tax liability.

Municipal bonds also offer a compelling opportunity for investors to achieve their financial goals with less risk. With attractive yields meeting low default risk, investors may have a compelling opportunity to lock-in tax-exempt yields within an asset class of exceptional creditworthiness.

Here are some key statistics that highlight the benefits of municipal bonds:

Investing in bonds can be a great way to stabilize your finances, and one type of bond that stands out is the municipal bond. Here's why: municipal bonds have low default rates, making them a relatively safe investment option.

Municipal bonds also offer tax benefits, as the interest earned is generally exempt from federal taxes. This can be a significant advantage, especially for those in higher tax brackets.

The stability of municipal bonds is backed by data from the Securities Industry and Financial Markets Association, which reports low default rates.

Tax-advantaged income is a major benefit of municipal bonds. They offer tax-free income for qualified residents, which can be a significant advantage, especially for high-income earners.

The default rate for municipal bonds is very low, at 0.10% over the last ten years, according to Bloomberg. This low default risk makes municipal bonds an attractive investment option.

Taxable bonds, on the other hand, may have a higher pretax yield, but investors need to consider the tax obligations of that bond. Only after accounting for taxes can investors accurately compare its yield with that of a tax-exempt bond.

Here are some tax-advantaged income benefits of municipal bonds:

Municipal bonds offer relative value to bonds with similar risks, especially when considering the tax advantages. Taxable equivalent yields (TEYs) for certain high-bracket investors can be more than double those offered by comparable taxable securities.

For your interest: Taxation of Corporate Bonds

Our team of Senior Portfolio Managers is comprised of experienced professionals who have a deep understanding of the investment landscape. Jason Appleson, CFA, FRM, serves as the Head of Municipal Bonds, bringing a wealth of knowledge to the table.

Jason Appleson, CFA, FRM, has a strong background in municipal bonds, which is evident in his leadership role.