Also under consideration is a proposal to make the capital-gains tax equal to an individual’s marginal tax rate. The current maximum rate is 23.8%: the 20% capital gains rate plus 3.8% for the Affordable Care Act (ACA) tax. If Congress approves the Biden proposal, the combination of a new 39.6% marginal tax rate and the 3.8% ACA tax means the wealthy could be faced with a staggering 43.4% capital-gains tax bill.

It’s not just wealthy individuals who need to worry about higher tax rates. Corporations are faced with the potential for their taxes to rise from 21% to 26%—which is still lower than the 35% rate they paid through 2017. Nevertheless, it could represent a meaningful decline in cash flow when all is said and done.

Given the angst about paying more taxes, many investors have been turning to the municipal-bond market to potentially help shield some of their income. Morningstar estimates that, through the end of August, municipal-bond mutual funds and ETFs have seen more than $62 billion in inflows, putting them on pace for one of their best years in history (FIGURE 1). And don’t rule out corporations getting back into the mix. After tax cuts went into effect in 2018, banks cut their municipal-bond holdings by roughly $70 billion through Q3 2020¹ as the tax-saving incentives no longer made sense. If taxes move higher, large banks and insurance companies could become a larger force in the municipal-bond market. 

Potentially higher taxes and increased demand are solid reasons alone to consider increasing allocations to the space. We’d also argue that investors should consider municipal bonds as a core allocation based on a number of other factors, namely: strengthening fundamentals, high-quality characteristics, and low interest-rate sensitivity.

Strengthening Fundamentals

In March of 2020, as markets swooned in response to the onset of COVID-19, the US government passed the Coronavirus Aid, Relief, and Economic Security (CARES)  Act, which included $150 billion in payments made directly to state and local governments.² Since then, most of these governmental aid recipients suffered a less substantial financial hit from the pandemic than was initially expected. Essentially, many are getting more money than they may need. For example, as of August 2021, the state of New York had spent only $378.8 million of the $12.7 billion it was allocated according to a report by Bloomberg.³ While some aid recipients have certainly had to spend varying shares of their allocations, others have actually found themselves in a surprising position of strength.

In addition, the Biden administration hopes to invest as much as $4.5 trillion as part of its Build Back Better infrastructure agenda.⁴ Tens of billions of dollars are being earmarked for roads and bridges, public transit, power-grid infrastructure, and airports, among other public programs. All of this is to say: The support municipalities have received, and are scheduled to receive, is staggering. In our view, their balance sheets should remain robust, offsetting any slowing growth in the overall economy.

High-Quality Characteristics

In addition to benefiting from strong government balance sheets, municipal bonds have experienced low default rates historically. Over the long term, municipal-bond strategies have generally exhibited the positive attributes that many investors seek from a bond allocation—a core holding that helps dampen volatility and complements equities. In fact, municipal bonds may be better-suited for these purposes than some investment-grade (IG) corporate bonds (which by August 2021 represented 26% of the Bloomberg US Aggregate Bond Index).⁵

In addition to benefiting from strong government balance sheets, municipal bonds have experienced low default rates historically.

Historically, municipal bonds have defaulted at a much lower rate than similarly rated corporate bonds. Currently, the municipal default rate is one-twentieth of the corporate default rate for investment-grade rated bonds.⁶ Furthermore, during times of economic and geopolitical stress—the very moment when investors are looking for stability—corporate default rates are often exacerbated. In 2020, more than 200 corporate bonds rated by Moody’s suffered defaults vs. just one for municipal bonds (FIGURE 2).

The structure of municipal securities, vs. that of corporates, inherently lends itself to lower defaults. That’s because many municipalities are required to keep balanced budgets, have the ability to raise taxes while cutting expenses, benefit from steady cash flows from taxpayers, and typically have restrictions and prohibitions from adding additional risk and leverage. These characteristics have traditionally helped municipal bonds find a potentially suitable fit within core-bond allocation strategies.

Duration tends to focus solely on changing rates while failing to incorporate other variables such as credit spreads or general supply-demand factors.

Historically Low Sensitivity to Rate Changes

Effective duration is the measure of a bond or bond fund’s interest-rate risk, thus providing a theoretical measure of the price change in a bond given a change in interest rates. The longer a fund’s duration, the more a fund’s returns are potentially at risk in response to a rise in interest rates. However, duration tends to focus solely on changing rates while failing to incorporate other variables such as credit spreads or general supply-demand factors.

Municipal-bond returns have historically been less impacted by rising rates than other asset classes such as US Treasuries and investment-grade corporate bonds. You don’t have to look much farther than the past year to see the evidence. In August 2020, the 10-year Treasury (10-year) rate hit its record low at 0.51%. By the end of August 2021, the 10-year had risen approximately 80 basis points to 1.30%. By contrast, the Bloomberg Municipal Bond Index gained 1.53% while the Bloomberg US Aggregate Bond Index (Agg) lost 0.69%—over 2.20% of outperformance.

During this time frame, the Agg averaged a duration of 0.7 years longer than the duration of the Bloomberg Municipal Bond Index—but that by itself doesn’t account for the significant return gap. Historically, the empirical duration for municipal bonds, which is the calculation of a bond’s duration based on historical data, has been about half of its effective duration calculation dating back to April 2012.

Put another way, while effective duration is a theoretical measure of how prices may react to changing rates, empirical duration uses regression analysis of actual changes in bond prices and yields. The difference that results between effective and empirical duration can tell us a lot regarding the other factors that drive bond prices (i.e., credit spreads, supply vs. demand, cash flows). While the average effective duration over this time for the Bloomberg Municipal Bond Index is higher than the Agg’s, its empirical duration based on historical data is actually lower (FIGURE 3).

The takeaway here is that investors can potentially benefit by broadening their focus beyond interest and effective duration only. The potential for tax-rate increases and the impact of supply-demand dynamics are factors that are equally important when considering the potential benefits of the municipal-bond asset class, particularly at a time when interest-rate risk seems top-of-mind in the current environment.

Investors can potentially benefit by broadening their focus beyond interest and effective duration. 

Summary

Limiting taxes has always been a priority in financial planning. The specter of higher tax rates has been a driving force behind flows in 2021 and may encourage wealthy investors, banks, and insurance companies to seek the potential benefits of municipal bonds. Massive stimulus from infrastructure programs should be supportive of municipal balance sheets, which have historically been more resilient than their corporate counterparts. Finally, in the current low interest-rate environment, a focus on hedging against the potential for rising rates should be a concern. Nevertheless, investors shouldn’t rely solely on effective duration when judging fixed-income opportunities.