Municipal bonds often conjure up images of golfers taking in a few rounds at the country club before shopping for their dream yachts.
But as we see it, municipal bonds (aka muni bonds) aren’t just an investment option for the wealthiest investors. In fact, many fixed-income investors, regardless of their tax bracket, may want to consider muni bonds.
So what’s the deal with muni bonds? As background, they are issued by states or local governments to finance public works and infrastructure projects. They are generally exempt from federal taxes and are often exempt from state and local taxes (although investors may be subject to the federal Alternative Minimum Tax).
This tax advantage is what has given muni bonds and wealthy investors their reputation; the tax benefits tend to help those in the highest tax bracket because they’re more pronounced.
Tax Reform and the Muni Market
Some of the provisions in the Tax Cuts and Jobs Act that went into effect in 2018 impacted the muni market. The new legislation lowered tax rates for businesses from 35% to 21% and lowered the highest tax rate for individuals from 39.7% to 37%. It also limits an individual’s state and local tax deductions to $10,000.
But even with these changes, the following five reasons explain why municipal bonds may still make sense for many investors, not just the rich:
1. Municipal bond defaults are infrequent. According to a Moody’s report, the overall default rate from 1970-2018 was only 0.10% for muni bonds.1 Compare that to global corporate bonds, which defaulted at a 6.6% rate over that same time frame.1 It’s important to note that the overall muni default rate remained that low despite 2017 having the highest municipal defaults volume on record, mostly related to Puerto Rico, and that a bond issuer up against hard times can be downgraded in quality without defaulting.
2. Municipal bonds tend to move independently of equity markets. Because they are domestically focused, muni bonds generally lack exposure to the same concerns and sources of volatility that global equities face. So when equity markets gyrate, muni bonds can serve as an important diversification complement within your portfolio.
3. Because municipal bonds seek to provide tax-free income, they have generally offered higher tax-equivalent yields than their taxable counterparts. For example, as of March 31, 2020, muni bonds were yielding 2.01% and 10-year US Treasuries were yielding 1.91% before taxes. But after considering the impact of taxes, the taxable-equivalent yield (the return required on a taxable bond to make it equal to the return of a tax-exempt bond) of municipal bonds was even more attractive, 3.19%, for investors in the highest (37%) tax bracket. Investors in all of the seven tax brackets would have seen higher after-tax returns from municipal bonds than US Treasuries or other taxable bonds (FIGURE 1).
The Taxable-Equivalent Yield of Municipal Bonds Benefits Investors in Most Tax Brackets
Distribution Yield % as of 3/31/20
Data sources: FactSet and Hartford Funds, 4/20. Municipal bonds are measured by the Bloomberg Barclays Municipal Bond Index, core taxable bonds are measured by the Bloomberg Barclays US Aggregate Bond Index, and government bonds are measured by the Bloomberg Barclays Government-Related Index. See index definitions below for more information. The calculation for distribution yields employs the most recent distribution, which may be interest, a special dividend, or a capital gain, and multiplies the payment by 12 to get an annualized total.Past performance does not guarantee future results.
Past performance is not indicative of future results. The performance shown above is index performance and is not reflective of the performance of any fund. Indices are unmanaged and not available for direct investment.
4. Muni bonds historically have had a favorable supply/demand balance. Demand set record highs in 2019, but in March 2020, uncertainty surrounding the COVID-19 pandemic led to a supply glut for the first time since 2013. While it will take some time to determine the full impact of the pandemic shutdown on muni issuers, investor demand for ways to help reduce taxes will always exist. In addition, the government has taken steps that should support the muni market and help rebalance supply and demand. For example, the Coronavirus Aid, Relief, and Economic Security (CARES) Act authorized the US Treasury to provide billions of dollars of relief to municipalities, airlines, and other businesses, and the US Federal Reserve (Fed) pledged to help keep fixed-income markets functioning smoothly.
5. Municipal bonds have tended to generate positive returns regardless of the interest-rate environment. The Fed began raising interest rates, or “tightening” policy, in 2015. In 2019, they put their rate increases on hold and cut rates as economic conditions shifted, and cut them to near zero in 2020 in response to the COVID-19 pandemic. Regardless of how the Fed’s policies change going forward, muni-bond returns aren’t likely to be significantly impacted by the interest-rate environment. Figure 2 shows that muni-bond performance has been interest-rate agnostic: On average, muni bonds have posted positive returns whether interest rates were rising, stable, or declining.
During the Last 30 Years, Muni Bond Returns Have Been Positive Regardless of the Interest-Rate Environment
Bloomberg Barclays Municipal Bond Index Average Monthly Returns (%) March 1990 - March 2020
Data sources: FactSet, NDR, Morningstar, and Hartford Funds, 4/20. A tightening cycle is considered at least three consecutive rate increases without an intervening easing cycle. An easing cycle is considered at least two consecutive rate cuts within a 12-month period without an intervening rate hike. The performance shown above is index performance and does not reflect the performance of any fund. For illustrative purposes only.
The More You Know
In short, municipal bonds aren’t an asset class reserved just for the rich. There are many reasons to consider including municipal bonds as a core holding in your fixed-income portfolio, regardless of your tax bracket. But like all investments, they have opportunities and risks to consider first.
Talk to your financial professional today to see if tax-free municipal bonds are the right choice for you.
Hartford Funds Tax-Advantaged Bond Funds*
1 Moody’s Investors Service: “US Municipal Bond Defaults and Recoveries, 1970-2018”
Bloomberg Barclays Municipal Bond Index is an unmanaged index of municipal bonds with maturities greater than two years.
Bloomberg Barclays US Aggregate Bond Index is composed of securities from the Bloomberg Barclays Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index.
Bloomberg Barclays Government-Related Index is a universe of Treasury bonds used as a benchmark against the market for long-term maturity fixed-income securities. The Index assumes reinvestment of all distributions and the interest payments.
Additional Information Regarding Bloomberg Barclays Indices Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Municipal securities may be adversely impacted by state/local, political, economic, or market conditions. Investors may be subject to the federal Alternative Minimum Tax as well as state and local income taxes. Capital gains, if any, are taxable. Diversification does not ensure a profit or protect against a loss in a declining market.
This information should not be considered investment advice or a recommendation to buy/sell any security. In addition, it does not take into account the specific investment objectives, tax and financial condition of any specific person.
This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. This material and/or its contents are current at the time of writing and are subject to change without notice. This material may not be copied, photocopied or duplicated in any form or distributed in whole or in part, for any purpose, without the express written consent of Hartford Funds.