How To Decide If Municipal Bonds Are Right For You

by: Charles Schwab
Summary

How do you decide whether to invest in municipal bonds versus taxable alternatives like corporates or Treasuries?

What's your tax bracket?

Are you investing in a taxable or tax-advantaged account?

Are you investing in short-term or long-term bonds?

By Cooper J. Howard

How do you decide whether to invest in municipal bonds versus taxable alternatives like corporates or Treasuries?

Historically, your tax bracket was the primary factor, but we believe you should consider factors beyond just your tax rate. Also, short-term rates on muni bonds have recently fallen to a point where you may achieve higher after-tax yields in corporate or Treasury bonds.

Here are some factors to consider before deciding:

What's your tax bracket?

Munis tend to make the most sense for investors in higher tax brackets. Municipal bond interest is generally exempt from the following taxes:

  • Federal income taxes
  • State income taxes if the issuer is in the investor's home state
  • The 3.8% Affordable Care Act (ACA) tax

Muni bonds' tax exemptions make them relatively more valuable to higher-income investors.

Are you investing in a taxable or tax-advantaged account?

Because of their tax benefits, muni yields are usually less than yields offered by corporate or Treasury bonds with comparable credit ratings and maturities. Therefore, munis make less sense in a tax-advantaged account-such as a traditional individual retirement account (IRA), Roth IRA, or 401(k) - where earnings are tax-deferred or tax-free. On the other hand, investors in a taxable account may be able to generate higher after-tax yields with municipal bonds if they are in a high tax bracket.

Are you investing in short-term or long-term bonds?

Muni yields have fallen more than Treasury or corporate yields recently. This is especially pronounced for short-term munis. The implication is that investors in taxable accounts may achieve higher after-tax yields by using taxable investments, like certificates of deposit (CDs), Treasuries, or corporate bonds for the short-term part of their fixed income allocation. However, at higher tax rates, short-term munis may still yield more than short-term taxable alternatives.

The chart below shows the yield curves for a benchmark AAA-rated muni index, the Treasury market, and an index of broad corporate bonds before considering taxes. At first glance, corporate bonds have the highest yield, but that's primarily because they're fully taxable and have greater credit risk than municipal bonds.

AAA-rated muni, Treasury, and corporate yield curves before taxes

Source: Bloomberg. Bloomberg BVAL (Bloomberg evaluated pricing service) Muni Benchmark Curve and USD US Corporate Investment Grade BVAL Curve, as of 4/4/2019.

Because corporate and Treasury bond interest is subject to income tax, it's appropriate to adjust them for taxes for a better comparison. In this instance, we chose two scenarios:

  1. A 24% federal and 5% state income tax rate. These scenarios are the solid blue and purple lines in the chart below.
  2. An investor in a high bracket - a 37% federal rate, 10% state income tax rate, and a 3.8% ACA tax rate. These scenarios are the dashed blue and purple lines in the chart below.

At the 24% federal rate, yields for both short-term Treasury and corporate bonds are greater than munis, but that yield advantage begins to disappear for Treasuries further out on the yield curve.

Meanwhile, at the higher tax rate, munis yield more than both Treasuries and corporates after taxes. If we adjust both curves for the top tax bracket, both short-term and long-term munis yield more than Treasuries after taxes.

AAA-rated muni, Treasury, and corporate yield curves at various tax rates

Source: Bloomberg, as of 4/8/2019. Assumes a 24% federal tax rate and 5% state tax rate for the 24% example and a 37% federal tax rate, 10% state tax rate, and 3.8% ACA rate for the 37% example. Interest payments on Treasury bonds are generally exempt from state income taxes, so a state tax rate was not included for Treasuries.

How much credit risk are you comfortable with?

Munis generally have higher and more stable credit ratings. As illustrated above, corporate bonds tend to have higher after-tax yields, but that's partly because the average credit quality of the corporate market is lower than that of the muni market.

Nearly two-thirds of the investment-grade muni market is composed of issuers with the top credit ratings - AAA and AA. This differs from the corporate market, where most issuers are clustered in the lower rungs of the investment-grade area. This is important for two reasons:

  1. If you're comfortable taking on greater credit risk, you may be able to achieve higher after-tax yields with corporate bonds. It's worth pointing out that the above yield curve examples used a AAA-rated muni yield curve index and a lower-rated one for corporates. AAA is the highest credit rating.
  2. If you're a conservative investor looking for highly rated investments, you may have an easier time doing so with munis. The flip side is also true - if you're looking for higher yields and are comfortable taking on greater credit risk, you may have an easier time finding bonds from different issuers in the corporate market.

There are more highly rated munis than corporates

Source: Bloomberg Barclays U.S. Municipal Bond Index and Bloomberg Barclays U.S. Corporate Bond Index, as of 4/3/2019.

The higher average credit ratings for munis generally mean lower default rates compared to corporate bonds. In fact, in a study going back to 1970, Moody's found that 0.1% of all investment-grade munis they rate defaulted over the next 10-year time period. This compares to 2.3% for all investment-grade-rated bonds that Moody's rates.1

Credit ratings also tend to be more stable in the muni market than in the corporate market. In a study going back to 1970, Moody's found that the rating on a corporate bond was more likely to be lowered after one year than the rating on a comparable municipal bond. For example, looking at AA-rated bonds in the table below, only 1.1% of all munis had a rating that was less than AA the following year. This compares with 9.1% for all corporate bonds. When a bond is downgraded it generally falls in price. (Note that the numbers do not add up to 100% because ratings may have been withdrawn for various reasons.)

Munis' ratings tend to change less than corporates

Initial Rating

Higher rating 1 year later

Lower rating 1 year later

Same rating 1 year later

Muni

Corporate

Muni

Corporate

Muni

Corporate

AAA

N/A

N/A

1.4%

8.6%

94.9%

87.7%

AA

0.3%

0.8%

1.1%

9.1%

94.7%

85.2%

A

1.8%

2.5%

0.7%

6.0%

92.9%

86.8%

Baa

3.5%

4.3%

1.9%

4.7%

89.6%

85.7%

Source: Moody's Investors Service, as of 7/31/2018.

What to do now

The decision between munis, corporates, or Treasuries doesn't have to be all or none. In some situations, you may be able to achieve higher after-tax yields without increasing credit risk too much with a combination of all three. However, consider the following to help you decide which to choose in your taxable account:

  • If you're in a 32%-or-above tax bracket, munis probably make the most sense regardless of where on the yield curve you're investing. Consider adding some lower-rated (BBB/Baa or A/A) munis if you're comfortable with added credit risk and are looking for higher yields. However, try to limit exposure to lower-rated munis to 30% of your portfolio.
  • If you're in the 24% tax bracket, consider Treasuries or CDs for the short-term part of your fixed income portfolio, and munis for the longer-term part of your portfolio. Consider adding some corporate bonds if you're comfortable with the added credit risk.
  • If you're in a tax bracket below 24%, CDs and Treasuries probably make the most sense. You could also consider adding some corporate bonds if you're comfortable with higher credit risk.

1 Source: Moody's Investors Service, "US Public Finance: US Municipal Bond Defaults and Recoveries, 1970-2017," July 31, 2018.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.