3 Reasons Why Municipal Bonds May Offer More Than Just Tax-Exempt Income

|
Includes: FMB, MUB, PRB, PVI, PZA, RVNU, TFI, VRD, XMPT
by: Invesco US

Summary

We believe higher tax rates increase the incentive for taxpayers to seek tax-exempt income using municipal bonds.

Municipals have the potential to offer a broad range of investment options that are exempt from federal income tax and, potentially, from state and local income taxes.

While municipal bonds are rightly renowned for generating tax-exempt income, there are several other reasons to consider them, including their relatively attractive yields, low default risk and diversification benefits.

By Stephanie Larosiliere

Tax-exempt income historically has been the main reason why investors buy municipal bonds. As a result of newer tax laws, including several provisions that expired at the end of 2013, tax bills for high-income earners have increased in recent years. Some of the significant changes to tax law include:

• A top marginal rate of 39.6%, up from 35%

• A 20% tax on long-term capital gains and dividends, up from 15%

• A new 3.8% tax on investment income, from which municipal income is exempt

We believe that these higher tax rates increase the incentive for taxpayers to seek tax-exempt income using municipal bonds. Municipals have the potential to offer a broad range of investment options that are exempt from federal income tax and, potentially, from state and local income taxes. In addition to those considerations, investing in this market has several other potential benefits that are often overlooked, including:

1. Attractive yields on a before- and after-tax basis, with relatively low volatility

The gap between perception and reality that was created in 2013 represents an opportunity for long-term investors who have a focus on after-tax income. As shown below, yields on municipal bonds, particularly high yield, are attractive relative to other fixed income asset classes - even on a before-tax basis. There is no guarantee that low-volatility stocks will provide low volatility.

LAROSILIERE_BLOG_1204_chart1

Source: Barclays, as of September 30, 2014. High Yield Municipal Bonds are represented by the Barclays High Yield Municipal Bond Index; High Yield Corporate Bonds are represented by the Barclays U.S. Corporate High Yield Index; Senior Loans are represented by the S&P/LSTA Index; Investment Grade Municipal Bonds are represented by the Barclays Municipal Bond Index; Investment Grade Corporate Bonds are represented by the Barclays U.S. Corporate Investment Grade Index; Broad Fixed Income are represented by the Barclays U.S. Aggregate Bond Index. Past performance is not a guarantee of future results. An investment cannot be made directly into an index.
* 2013 top marginal tax rate for single taxpayers with more than $400,000 in taxable income or couples with $450,000 or more. NIIT is the Net Investment Income Tax of 3.8% on investment income for single taxpayers with more than $200,000 in taxable income or couples with $250,000 or more.

2. Relatively lower default risk

Contrary to popular belief, the vast majority of municipal bond issuers remain creditworthy, and municipal default rates have remained relatively low, especially when compared with US corporate bonds. As shown in the chart below, when the credit structure decreases, the odds of a default rise. However, the percentages are much higher for investment-grade corporates compared with municipals. Since 1970, there has never been an Aaa-rated municipal bond default. Similarly, in the same time frame, only 0.01% have defaulted with an Aa-rating. By contrast, Aa-rated corporate issuances have had a nearly 1% default rate since 1970.1

LAROSILIERE_BLOG_1204_chart2

Source: Moody's Investors Service as of May 2014. A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. For more information on Moody's rating methodology, please visit moodys.com and select 'Rating Methodologies' under Research and Ratings on the homepage.

3. Diversification potential

Diversification can potentially increase opportunities for growth and reduce overall portfolio volatility. Because municipal bonds, more specifically high yield municipal bonds, have historically had very low correlation to other asset classes, including equities and Treasuries, they can be effective portfolio diversifiers.

Over the last 10-year period, ending Oct. 31, 2014, the Barclays High Yield Municipal Bond Index has exhibited a low 28% correlation with the S&P 500 Index. This is in contrast to the Barclays U.S. Corporate High Yield Index, which has had a much higher 73% correlation with the S&P 500 Index over the same time period. This lower correlation demonstrates that high yield municipal bonds have not moved to the same degree as their corporate counterparts when the equity market rises or falls. We believe that this low correlation can potentially enhance a portfolio's diversification benefits.

LAROSILIERE_BLOG_1204_chart3

Source: Morningstar, as of Oct. 31, 2014. Data from October 2004-October 2014. Changes in the value of two investments or asset classes may not track or offset each other in the manner anticipated by the portfolio managers, which may inhibit their risk allocation process from achieving its investment objective.

Talk to your advisor

While municipal bonds are rightly renowned for generating tax-exempt income, there are several other reasons to consider them as well, including their relatively attractive yields, low default risk and diversification benefits. Talk to your advisor to get more information about the benefits and risks of using municipal bonds in your portfolio.

Source 1: Moody's Investors Service, US Municipal Bond Defaults and Recoveries, 1970-2013, May 7, 2014

Important Information

Correlation indicates the degree to which two investments have historically moved in the same direction and magnitude.

Yield-to-Worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

Diversification does not guarantee a profit or eliminate the risk of loss.

Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer's ability to make payments of principal and/ or interest.

Most senior loans are made to corporations with below investment-grade credit ratings and are subject to significant credit, valuation and liquidity risk. The value of the collateral securing a loan may not be sufficient to cover the amount owed, may be found invalid or may be used to pay other outstanding obligations of the borrower under applicable law. There is also the risk that the collateral may be difficult to liquidate, or that a majority of the collateral may be illiquid.

High yield bonds invest in non-investment-grade bonds and are therefore subject to greater volatility than investment-grade bonds.

Securities which are in the medium- and lower-grade categories generally offer higher yields than are offered by higher-grade securities of similar maturity, but they also generally involve more volatility and greater risks, such as greater credit, market, liquidity, management, and regulatory risks.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.

The tax information contained herein is general and is not exhaustive by nature. It is not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding tax penalties that may be imposed on the taxpayer under U.S. federal tax laws.

The Barclays U.S. Corporate High Yield Index is an unmanaged index considered representative of fixed-rate, non-investment-grade debt. The Barclays High Yield Municipal Bond Index is an unmanaged index considered representative of non-investment grade bonds. The S&P/LSTA Leveraged Loan Index is a weekly total return index that tracks the current outstanding balance and spread over Libor for fully funded term loans. The Barclays Municipal Bond Index is an unmanaged index considered representative of the tax-exempt bond market. The Barclays U.S. Corporate Investment Grade Index is an unmanaged index considered representative of publicly issued, fixed-rate, non-convertible, investment-grade debt securities. The Barclays U.S. Aggregate Bond Index in an unmanaged index considered representative of the US investment-grade, fixed-rate bond market. S&P 500 Index is an unmanaged index considered representative of the US stock market. The MSCI EAFE Index is an unmanaged index considered representative of stocks of Europe, Australasia and the Far East. The index is computed using the net return, which withholds applicable taxes for non-resident investors. The MSCI Emerging Markets Index is an unmanaged index considered representative of stocks of developing countries. The index is computed using the net return, which withholds applicable taxes for non-resident investors. The Russell 2000 Index is an unmanaged index considered representative of small-cap stocks. The Russell 2000 Index is a trademark/service mark of the Frank Russell Co. Russell® is a trademark of the Frank Russell Co. The Barclays U.S. Government Bond Index is an index that measures the performance of all public U.S. government obligations with remaining maturities of one year or more.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE

All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the U.S. distributor for Invesco Ltd.'s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.

©2014 Invesco Ltd. All rights reserved.

blog.invesco.us.com

About this article:

Expand
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here