During 2019, a substantial increase in taxable municipal bond issuance renewed investor interest in the asset class. Taxable municipal bond issuance, so far, has continued at high levels through the first months of 2020, reports The Bond Buyer in February. Here, we reexamine the taxable market for readers and share some thoughts about this subset of municipal bonds.
Let’s start with a definition. Taxable municipal bonds (taxables) in contrast to tax-exempt municipal bonds (tax-exempts), are not eligible for the federal tax exemption that typically applies to municipal interest payments. Municipal bonds can be made ineligible for the exemption for a variety of reasons that go beyond the scope of this article, but in all cases, taxable issuances fail the IRS’s strict tax-exempt financing guidelines. Taxables are commonly issued to:
- Foster economic development
- Speed regulatory approval and reduce issuance costs
- Refinance (or advance refund) prior bonds
- Recapitalize underfunded pension plans
Taxable Municipal Bonds: Resurgence under New Tax Law, Low Rates
A change in tax law and an extended period of prevailing low interest rates is driving more taxable issuance. The Tax Cuts and Jobs Act (TCJA) of 2017 eliminated the tax exemption for municipal bonds that are issued to accomplish advance refundings. Advance refundings enable bond issuers to retire higher interest-rate debt prior to a bond’s call date, replacing it with a new bond issued at a lower interest rate.
Before the TCJA, advance refundings represented a significant portion of tax-exempt bond issuance. While the tax-exemption for advance refundings went away, prevailing low interest rates meant that many issuers could advance refund their tax-exempt debt using taxable municipal bonds instead.
During 2019, a confluence of circumstances resulted in issuance of taxables at the highest levels since the Build America Bonds (BABs) program in 2010 (Figure 1). Taxable issuance in 2019 was approximately 25 percent of total municipal bond issuance, a substantial proportion – even though taxables still represent just 13% of the overall municipal bond market (Bloomberg).
Taxable Municipal Bonds Can Offer Relative Value Opportunities in Low-Yield Environments
Taxables are often ineligible for the tax-exemption because they are sometimes issued to less essential public projects. Nevertheless, taxable are typically highly rated bonds offered by well-known issuers and, most often, they are backed by the same types of security pledges as tax-exempt bonds (Bloomberg).
Taxable municipals can offer value on several dimensions. While many investors will choose tax-exempt municipal bonds because their tax benefits can compensate for relatively lower yields, taxables may offer after-tax yields that are higher in absolute terms and after taking an individual’s current tax bracket into account.
Figure 2 compares the Municipal/Treasury (M/T) Ratio Curves for bonds with maturities from 2 to 10 years. M/T Ratios measure the yield offered by tax-exempt municipal bonds as a percentage of that of Treasuries. The chart shows the ratios at June 28, 2019 and at January 31, 2020 and presents the average ratios for those maturities during the last three years ended January 31, 2020. The chart illustrates the substantial decline in the ratios of municipal bond yields compared with Treasury bonds. At these low levels and depending on the investor’s tax bracket, taxable municipal bonds may offer opportunities to capture relatively higher yields in a portfolio on an after-tax basis.(To find out more about M/T ratios and their role in bond evaluation, see Low Yields Elevate Value of M/T Ratios, Crossover Trades.)
In addition, beyond the fundamental characteristics that attract many investors to taxable municipals, non-traditional buyers, including institutional and foreign investors, have demonstrated higher levels of acceptance of the asset class during the last two years due to low global yields, according to Bloomberg Barclays data.
Relative Value Is Important To Your Investment Strategy
Relative value is an important concept for investors to keep in mind. Relative value is the attractiveness measured in terms of risk, liquidity and return of one financial instrument relative to another.
Breckinridge believes that tax-efficient investors can benefit when the value of additional opportunities, like taxable municipals, increases relative to tax-exempts. Focusing solely on tax-exempts, disregarding anomalies in relative value could lead to ignoring risks and missing potential opportunities.
Breckinridge can make these relative value assessments because of our broad capabilities across domestic fixed income markets coupled with the close collaboration of our investment teams. At Breckinridge, we believe that our capabilities across investment-grade asset classes give us a competitive foothold in the tax-efficient marketplace.
Federal and local tax laws and rates can change at any time; changes to tax laws and rates can impact tax consequences for investors. Investors should consult with their tax professionals prior to making any investment decisions for tax purposes.
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