Searching For Tax-Exempt Yield? Go Beyond The Benchmark

by: Columbia Threadneedle Investments

By Catherine Stienstra, Head of Municipal Investments

Revenue bonds are secured by the revenue stream generated from the specific income-producing project that’s being financed. Sometimes, in transactions known as conduit financing, municipalities issue revenue bonds on behalf of private entities that subsequently assume full responsibility for debt repayment. Conduit bonds can be issued by hospitals or health systems, private colleges or universities, or other charitable organizations. Without direct government ties, these bonds may be perceived as carrying greater risk. And this could explain why many traditional indices have significant exclusion rules that primarily target revenue bond sectors.

For example, the S&P National AMT-Free Municipal Bond Index specifically excludes conduit issuers, and the Bloomberg Barclays Municipal Managed Money Index excludes hospitals and housing bonds. These exclusions concentrate exposure in the few remaining sectors that are more explicitly tied to governmental activities: tax-backed, water and sewer, public education and transportation. This approach forfeits access to a broad swath of market opportunity and results in an over-representation of lower yielding general obligation debt.

Potential opportunity: Revenue bond sectors offer higher yields

In the last decade, several high-profile municipal downfalls, driven by long-term budget mismanagement, have challenged the sanctity of the GO pledge. More importantly, bond investors have found themselves at the mercy of not only a municipality’s ability to pay, but of their willingness to do so. Detroit and Stockton, for example, emerged from bankruptcy by making cuts to bondholders while largely preserving pensions for retirees. These examples and other recent experiences suggest that GO debt, often valued for its perceived safety and security, is not immune to impairment.

Despite this, GOs experience persistent demand that drives yields lower than many similarly rated alternatives. Representing nearly 70% of the market, revenue bonds lack the taxing authority of state and local governments and often trade at a discount to their GO counterparts. This represents ample opportunity for investors to pick up incremental income and potentially improve risk-adjusted returns — particularly in housing and hospitals, two sectors often excluded from prevailing indices.

Bottom line

Not all segments of the municipal market offer the same income opportunities. Investing across sectors can increase yield potential.

S&P National AMT-Free Municipal Bond Index is a broad, comprehensive, market value-weighted index designed to measure the performance of the investment-grade tax-exempt US municipal bond market. Bonds issued by US territories, including Puerto Rico, are excluded from this index.

Bloomberg Barclays Municipal Managed Money Index is an unmanaged index that is rules-based, market-value weighted engineered for the tax exempt bond market. All bonds in the National Municipal Bond Index must be rated Aa3/AA- or higher by at least two of the following statistical ratings agencies: Moody’s, S&P and Fitch.

Income from tax-exempt municipal bonds or municipal bond funds may be subject to state and local taxes, and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal income tax rules will apply to any capital gains.

Investing involves risk including the risk of loss of principal.

The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate.

Columbia Funds and Columbia Acorn Funds are distributed by Columbia Management Investment Distributors, Inc., member FINRA. Columbia Funds are managed by Columbia Management Investment Advisers, LLC and Columbia Acorn Funds are managed by Columbia Wanger Asset Management, LLC, a subsidiary of Columbia Management Investment Advisers, LLC.

Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.

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