What municipal bonds offer investors in today’s markets

July 23, 2021

MUNICIPAL BONDS ARE ENJOYING A MOMENT in the spotlight. Issued by state or local governments to finance construction projects or other needs, municipals, or “munis,” are often seen as relatively safe but sedate investments best known for steady, generally tax-exempt returns. Yet with possible tax rate increases on the horizon and credit quality on an uptrend, “municipal bonds are hitting on all cylinders,” says David Litvack, tax-exempt strategist in the Chief Investment Office (CIO) for Merrill and Bank of America Private Bank.

“For bond investors, especially high earners hoping to reduce their tax exposure, now could be a time to consider munis over U.S. Treasurys or corporate bonds,” says Litvack, author of a new “Fixed Income Strategy” report from the CIO. Here, he answers key questions about the advantages and risks of municipal bonds, why they might (or might not) fit your portfolio and what to discuss with your financial advisor.

Q: Why are municipal bonds performing so well?

A: Demand has risen among investors concerned about possible tax increases, while the supply of new municipal bonds has been relatively limited. Moreover, their credit quality has improved after fears that last year’s pandemic-driven recession could lead many cash-strapped governments to default proved largely unfounded. In fact, total state and local tax revenues for 2020 rose almost 2% from 2019, according to the U.S. Census Bureau, and federal stimulus is promising hundreds of billions of dollars of additional support to governments, transit agencies, airports, higher education and hospitals.

All told, municipal bonds have performed comparatively well so far in a year when bonds have generally struggled. While year-to-date Treasury and corporate bond returns were down more than 3% each, the overall municipal bond index was up 0.68%.¹

Q: What are their tax advantages?

A: While most bond interest is taxed as ordinary income, interest on municipal bonds is typically free from federal income taxes, as well as state and local taxes (generally as long as the bonds are issued in the state where the taxpayer resides). Though their nominal yield is usually lower than for taxable bonds, they may provide a higher after-tax return. Say you’re a taxpayer in the highest (37%) federal bracket and subject to the 3.8% Medicare surtax and 8% state and local taxes. At a combined 48.8%, you would need a corporate bond yielding at least 3.91% in order to earn more, after taxes, than from a tax-exempt municipal bond yielding just 2%.

Another important benefit is low credit risk. Despite some high-profile defaults, from 1970 to 2019 the average annual default rate on an investment grade municipal bond has only been about 0.01%, according to Moody’s.

Q: What role can they play in my portfolio?

A: While economic recovery and growth favor portfolios weighted towards stocks, bonds remain essential for diversification, income and stability. In the portion of the portfolio devoted to bonds, investors might consider increasing the percentage of municipal bonds, especially if they’re concerned about taxes. Yet as demand drives prices higher, it will be important to consider the relative value of munis versus taxable fixed income instruments. In some cases, especially for investors in lower tax brackets, Treasurys or corporate bonds may still be the better way to go.

Q: How can I work with my advisor to build the muni bond portion of my portfolio?

A: Investors with specific preferences could select individual bond offerings using separately managed accounts. But you would need a sizeable number of these in order to properly diversify. Mutual funds or exchange-traded funds (ETFs) generally provide greater diversification, especially for investors with a smaller amount to invest.

If your primary goal is income, you might consider bond laddering—buying bonds with successive maturity dates—to generate a regular cash flow and help to mitigate the risk of rising interest rates. Another consideration is credit quality. Depending on your risk appetite, you might choose somewhat lower-rated municipal bonds that offer higher yields but entail more credit risk.

Q: What risks should I consider?

A: Though they are typically among the safer investments, municipal bonds do carry risks. Beyond the slim but real possibility of default, bonds can lose value if the issuer’s credit rating is downgraded. Also, as with any fixed income investment, inflation can erode the purchasing power of future income. Likewise, when interest rates go up, the value of bonds declines. That’s why, with rates and inflation rising, the Chief Investment Office currently suggests investors consider purchasing bonds with a shorter duration.

Liquidity can be another issue. As witnessed during the early days of the pandemic, municipal bonds may be hard to sell during times of market disruption. Still, for the right investor in the appropriate circumstances, munis’ generally tax-exempt status and lower default rate, relative to corporate bonds, may make for an attractive combination. Before making any decisions, be sure to speak with your advisor and tax specialist about your tax situation, risk preferences and return requirements.