Higher issuance of federally taxable municipal bonds during 2020 is bringing renewed attention to a sometimes-underappreciated segment of the bond market. Investors in taxable and tax-exempt strategies are welcoming the 2020 surge because taxable municipal bonds can enhance portfolio characteristics due to their relative quality, value and returns while still providing tax benefits.
The taxable municipal bond market is relatively small
Historically, the taxable municipal bond market has been relatively small. Based on SIFMA data as of the end of the first quarter of 2020, the corporate bond market was about $9.5 trillion.1 Barclays set the size of the tax-exempt municipal bond market at about $3.3 trillion, as of September 2, 2020.2 In the same report, Barclays estimated taxable municipal bonds could reach $650 billion by the end of 2020. Despite the surge in issuance, the taxable municipal market remains small compared to the corporate bond market where net new issuance in 2020 was $903 billion through August, per Barclays.
Taxable bonds jump
A notable increase in issuance and market conditions brought heightened attention to taxable municipal bonds in 2020. After nearly a decade of averaging about 10 percent of annual municipal bond issuance, during 2020 taxable municipal bond issuance jumped to 30 percent of total issuance, per The Bond Buyer. In a year when tax-exempt municipal bond issuance has been relatively flat, the accelerated taxable municipal bond issuance is particularly noteworthy.
Issuers choose taxable bonds for many reasons
There are reasons state and local governments issue municipal bonds that are subject to federal income taxes. Taxable municipal bonds may be intended to finance projects that do not meet Internal Revenue Service requirements to qualify for tax exemption; examples of these include funding for a sports facility or industrial development. Also, municipal bonds that are issued to improve public pension funding levels or refund previously refunded municipal bonds are not federally tax exempt. In addition, regulatory requirements can be more conducive to taxable municipal bond issuance. The Tax Cuts and Jobs Act of 2017 eliminated the use of proceeds from new tax-exempt bonds to refinance older, higher interest rate municipal debt.
In addition, market conditions in 2020 support taxable municipal bond issuance. A low-yield environment makes retiring existing debt with taxable municipal bonds more attractive.
Places for taxable municipal bonds in portfolios
For investors, the increased supply of taxable municipal bonds may mean more opportunity to add securities with favorable fixed income characteristics to their portfolios. A look at key characteristics of Bloomberg bond indexes illustrates relevant differences and similarities of corporate, federally taxable municipal and tax-exempt municipal bonds with intermediate maturities.
Relative credit quality and value are important perspectives to consider when comparing sectors. Based on the averages in Table 1, intermediate taxable municipal bonds offer comparable quality as intermediate tax-exempt municipal bonds, and both have higher average credit quality than intermediate corporate bonds.
Returns and yield for intermediate taxable municipals bonds are higher than intermediate tax-exempt bonds and corporate bonds, while offering similar maturity and duration.
Multi-sector or sector-focused? Both, under the right circumstances.
At Breckinridge, we include taxable municipal bonds in our multi-sector portfolios due to the diversification and value benefits we believe they can deliver relative to the corporate and government (i.e., tax exempt) bonds in the same portfolio. As we have seen in Table 1, taxable municipal bonds can offer attractive yields, higher credit quality and lower volatility compared with corporate bonds. In addition, like their tax-exempt counterparts, taxable municipal bonds historically have had lower default rates than corporate bonds.3 Communities often consider the projects that the bonds finance to be essential and they prioritize revenues to meet principal and interest obligations.
For tax-efficient strategies, we prioritize tax-exempt municipal bonds but in certain market conditions, taxable municipal bonds can offer relative value. As indicated in Table 1, taxable municipal bonds were offering higher yields than comparable tax-exempt bonds at September 30, 2020. This is consistent with historical norms, based on our observations, as the higher yield offered by taxable municipal bonds has tended to compensate investors for the lost tax benefit. Interest-rate conditions and the yield environment must be right for the yield of a taxable municipal bond to contribute a better after-tax return than a tax-exempt bond. In 2020, for example, the Federal Reserve’s zero lower bound interest-rate policy and the low overall yield environment for tax-exempt municipal and other bonds offer, in combination, favorable conditions for considering some allocation to taxable municipal bonds in a tax-exempt portfolio, depending on an investors tax planning goals. For that reason, limited allocations to taxable municipal bonds within tax-efficient strategies are made only when we believe market conditions warrant.
While they may be unfamiliar to some investors, taxable municipal bonds can play beneficial roles in multi-sector and sector-focused portfolios. The surge in taxable municipal bond issuance in 2020 is offering investors additional opportunities to seek diversification across their portfolios.
 Securities Industry and Financial Markets Association (SIFMA) data, at September 24, 2020.
 Barclays data as of September 2, 2020.
 ”From 1970 through 2019, the average five-year annual default rate for municipal bonds rated by Moody’s Investors Service was 0.08%. Corporate bonds, which have lower ratings, had a 6.7% default rate over the same period.” Insurers Seen Boosting Muni Stakes As Yields Surpass Corporates, “FA Financial Advisor,” July 27, 2020. https://www.fa-mag.com/news/insurers-seen-boosting-muni-stakes-as-yields-surpass-corporates-57092.html
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