Taxable Munis — Value Amidst the Winds of Change in Today’s Muni Market?
By Greg Serbe, December 9, 2019
The municipal bond market has always been seen as a quiet, but rewarding, portion of the fixed income market. While many investors love to share their latest equity successes, rarely do they spend time bragging about their investment in a school district, water filtration plant, or other infrastructural project funded by tax free municipal bonds. While not having the same cocktail party cachet as an equity IPO, these bonds do provide a potential bedrock for a portfolio’s stability. Because it is such a quiet part of the market, change comes slowly but inexorably.
In the 1980’s Congressional action led to federal regulation of the municipal bond market. As interest rates declined from the dramatically high early 1980’s, the number of times a municipality could advance refund its older, higher cost bonds with new lower rates was limited to one refunding. Other types of municipal bond financings were denied tax free status. The interest paid on these bonds would not be free from federal tax.
In the fall of 2017, the new Tax Cuts and Jobs Act eliminated all advance refunding of tax-free municipal bonds, starting in January 2018. There was a rush to advance refund as many older issues as possible, but eventually the window was closed.
A broader taxable municipal bond market developed. In 2009, the federal government offered to pay 35% of the interest due on municipal bonds issued as “Build America Bonds,” but the interest would be subject to federal taxation. The hope was that the lower borrowing cost for the municipality would stimulate cities and states to create jobs through infrastructure construction. The market absorbed these bonds but within two years the authorizing legislation expired and was not renewed.
As a result of all these slow changes, a market for taxable municipal bonds developed. Naturally the rates paid by the municipality were in line with corporate bonds, since they all were subject to taxation. As mentioned above, at first many were issued to provide funds for projects that could not be financed through tax free bonds. For example, many states’ pension funds, having suffered from under funding and aggressive expectations as to the rate of growth of the fund, were the beneficiary of moneys borrowed by the state, in the taxable municipal bond market.
Who invested in these bonds? Many went to foreign investors who welcomed the credit stability of US assets. Others went to US investors for use in their IRA’s, where the higher interest rate paid by the municipality would grow in a tax-sheltered IRA. For years, I managed a bond fund that only invested in taxable municipal bonds.
Where are we now? This year, interest rates have declined. It is now possible for a municipality to advance refund older, higher interest rate debt with taxable municipal bonds backed by the same pledges of security that the tax free bonds had enjoyed. In recent data published in Bloomberg Intelligence, this year taxable municipal bond issuance has doubled over 2018. Currently approximately $54 billion in municipals have been issued this way for all purposes.
Aside from pensions and other buyers, who would be interested in these investments? In many instances, the bonds are exempt from state taxation. This becomes more important since the ability to deduct state and local taxes has been substantially limited due to the 2017 tax law change. Naturally any investor should determine if the specific issue is exempt on a state tax level, and should confer with a tax advisor as to the overall benefit of the investment.
Is there value in taxable municipals? In our opinion there is. Using some current evaluations of 10-year maturity bonds as a guide, let’s start with the Treasury Note. Currently it is yielding 1.74%. A blend of AA investment grade corporate bonds yield 2.40%. AAA rated taxable municipal bonds are yielding 2.36%. In our opinion, giving up 4 one hundredths of a percent to go to AAA quality for 10 years makes sense.
What are our thoughts about the entire municipal bond market? In our opinion, it continues to provide a relatively safe place for investment. In a Fact Sheet published this March by the Municipal Securities Rulemaking Board (“MSRB”), the MSRB quoted a default rate for investment grade municipal bonds of 0.18%, compared to 1.74% for corporate bonds for the 10-year period that includes the crash of 2008.
As always, we welcome your thoughts and comments.
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