Jim Colby, Portfolio Manager and Strategist, Municipal Bonds
March 20, 2018
As we approach the end of the first quarter of 2018, municipal bond performance has thus far followed a lackluster trajectory similar to those of the U.S. Treasury bond market. However, when we take a closer look at the numbers, we see signs that provide support to the asset class.
After a record-setting month of new issuance in December last year, expectations were set for a strong "January effect" as reinvestment dollars chased a significantly diminished new issuance calendar. This did not happen (see Where Was the 2018 January Effect?). Performance so far this year has been somewhat disappointing, but there are two significant characteristics of munis to point to that continues to favor the asset class: (1) ratios (of muni yields to those of U.S. Treasury and corporate bonds) continue to move lower; and (2) the taxable-equivalent yield comparative.
Analyzing the (Ratio) Spread
While evidencing a move towards long-term averages and appearing to be somewhat less than compelling, spread contraction actually tells a story of solid demand for the asset class. Demand keeps yields low, while the secular move to higher rates pushes upwards on U.S. Treasury and corporate bonds.
In one prominent example, the ratio of the Bloomberg Barclays Municipal High Yield Index to the Bloomberg Barclays U.S. Corporate High Yield Index has moved below 100%, but at 88% it remains above the long-term average of 79%.
Ratio of U.S. High Yield Corporate Index to High Yield Municipal Index Yields 10/31/95 - 2/28/18
Source: Bloomberg Barclays.
Looking at Taxable-Equivalent Yield
Comparing taxable-equivalent yield1 shows clearly the advantage of munis' tax-free coupon. Simply put, taxable-equivalent yield is calculated by dividing the yield of an AAA-rated (or even an A-rated)2 municipal by one minus the current highest personal Federal tax rate (e.g. 37%). The result can then be compared with whatever comparably-rated U.S. Treasury or corporate bond you might otherwise be interested in purchasing.
Here's an example using figures as of March 9, 2018: The AAA-rated 10-year muni bond yield was 2.49% and the U.S. Treasury 10-year bond yield was 2.89%. Using the formula above, the comparison of taxable equivalency produces a result of 3.95% versus 2.89%. This is a clear 106 basis point advantage from a Federal tax perspective for a municipal bond investment. We believe investors should never overlook this critical, and very simple, piece of analysis. It remains a very compelling reason to continue to allocate to this asset class.
Nominal vs. Taxable-Equivalent Yields as of 3/9/2018
1 Taxable-equivalent yield is used by investors to compare yields on taxable and tax-exempt securities after accounting for federal taxes (excluding AMT). Taxable-equivalent yield represents the yield a taxable bond would have to earn in order to match – after taxes – the yield available on a tax-exempt municipal bond. Taxable-Equivalent Yield = Tax-Free Municipal Bond Yield/(1 –Tax Rate).
2 The S&P rating scale is as follows, from excellent (high grade) to poor (including default): AAA to D, with intermediate ratings offered at each level between AA and C.
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Municipal bonds are subject to risks related to litigation, legislation, political change, conditions in underlying sectors or in local business communities and economies, bankruptcy or other changes in the issuer’s financial condition, and/or the discontinuance of taxes supporting the project or assets or the inability to collect revenues for the project or from the assets. Bonds and bond funds will decrease in value as interest rates rise. Additional risks include credit, interest rate, call, reinvestment, tax, market and lease obligation risk. High-yield municipal bonds are subject to greater risk of loss of income and principal than higher-rated securities, and are likely to be more sensitive to adverse economic changes or individual municipal developments than those of higher-rated securities. Municipal bonds may be less liquid than taxable bonds.
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Portfolio Manager and Strategist, Municipal Bonds
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