Should I Invest in Municipal Bonds?

This year’s tax filing deadline is Monday, April 18. It’s too late to plan for 2021 taxes, but not for 2022 taxes. Municipal bonds can be attractive investments for those in higher tax brackets because their income is exempt from federal income taxes. However, I find that clients are often confused about whether or not they should consider investing in municipal bonds. This article will help you know if muni bonds are right for you.

What is Your Marginal Tax Rate (MTR)?

To determine if municipal bonds might be an attractive investment for you, the first step is to estimate your marginal tax rate (MTR). This is the rate that you will pay on the last or “marginal” dollar of income (not your overall average tax rate). The table of tax brackets below is provided by the Tax Foundation:  

The higher your tax bracket (MTR), the more likely that municipal bonds will be an attractive investment for you.

Munis vs Corporates

The next step is to compare municipal bond yields with the yields available on other types of bonds. But which, Treasury bonds or corporate bonds?   Municipal bonds are generally thought to have a default risk level between that of Treasury bonds and corporate bonds. Treasury bonds are generally considered to be free from default risk (except by S&P!). There have been municipal bond defaults, but they are few and far between. Still, most analysts consider the overall municipal bond market to be a safer credit risk than the overall investment-grade corporate bond market. The U.S. municipal bond market has a weighted average credit rating of AA-, whereas the U.S. corporate bond market has a weighted average credit rating of A-. Investment grade bonds have a higher default rate, according to a recent Schwab study. From the standpoint of credit risk, mini bonds are between Treasurys and corporates, but probably a bit closer to corporates. 

Investors use bonds to diversify their stock market risk, which is the overwhelming risk in nearly all portfolios. The statistical measure of diversification is correlation—the lower the correlation with stocks the more an asset helps to diversify stock risk. Here again, munis are between Treasurys and corporates, as shown in the graph below. However, since 2020, muni correlations with stocks jumped up along with corporates, whereas Treasury correlations went down. This would indicate that, at least recently, munis have been behaving more like corporate bonds.

Most analysts have historically compared muni yields to corporate yields. Certainly, both munis and corporate are “spread product” that historically trade at a positive spread over Treasurys with similar maturities. However, with the Fed’s latest round of quantitative easing in the wake of the coronavirus pandemic, it is arguable whether Treasury yields are really more determined by the market or by central bank policy—Treasury yields may not even be “market” yields. For all of these reasons, I believe it makes sense to compare municipal bond yields with corporate bond yields (rather than Treasury yields).

Benchmark Funds

Vanguard Tax-Exempt Bond ETF (VTEB) is benchmarked to S&P National AMT-Free Municipal Bond Index, which captures the broad U.S. national muni market. “National” muni bonds do not focus on one state but invest broadly throughout the U.S. Therefore, VTEB is a good representation of the entire national municipal bond market. It is also the national muni ETF with the lowest expense ratio (.05%). 

The trick is to find a corporate bond ETF with which to compare it. Ideally, this would be an investment-grade corporate bond fund with the same level of interest rate risk. The statistic used to measure interest rate risk is “duration,” which is a measure of the amount that a bond, bond index, or bond fund would change in price give a 1% parallel shift in interest rates. For example, VTEB has a duration of 4.6, so if interest rates move up by 1% across the yield curve, its price can be expected to decline 4.6% based on its duration. 

Thankfully, there is an investment-grade corporate bond fund with a duration that comes very close to matching VTEB:  SPDR Portfolio Intermediate-Term Corporate Bond ETF (SPIB). That fund’s duration is 4.4. I would consider anything within about .5 to be a pretty good match.

Because we are in a rising interest rate environment, many investors wish to avoid having a very high duration in their bond investments. Therefore, in the graph below I have added short-term corporate and muni bond funds for comparison purposes. Combinations of the short-term and intermediate-term funds would lie along the straight lines between the two, allowing an investor to dial down their interest rate risk as desired.

30-Day SEC Yield

Notice in the graph above that the measure of yield is the “30-Day SEC Yield.”  I would like to emphasize that I believe it is critical to use the 30-day SEC yield as the basis of yield comparison among bond funds. This yield measure is designed to facilitate comparisons among bond funds. It is constructed by summing up income (whether accrued or received) over the past 30 days, subtracting expenses, and then dividing that figure by the bond fund’s highest price on the last day of the month, multiplied by the number of shares outstanding. All issuers of bond funds are required to supply this information to the public, but I have found that it is not easily obtained elsewhere. For example, neither ETF.com nor ETFdb.com include it in on their fund profiles. I find that the only place I can reliably obtain this yield measure is at the issuing company’s website. A hassle, to be sure, but worth it.

Other yield measures are readily available, including distribution yield, trailing 12-month yield, current yield, yield-to-maturity, and yield-to worst, to name the most common. These are, unfortunately, mostly useless become they lack comparability from one issuing company to the next. Fund companies have a lot of leeway in how they calculate their yield numbers and what they call the various types of yield that they present. I have found that the figures are all over the place for yields bearing the same name, even for highly similar bond funds—including passively managed funds using the same index benchmark!  

Comparison Calculations

The usual way to compare muni yields with corporate yields is to compute the “taxable equivalent yield” using the following formula:

     Tax Exempt Yield / (1 − Marginal Tax Rate)     =     Taxable Equivalent Yield

For example, Vanguard’s website recently listed the 30-day SEC yield for VTEB as 2.17%. (I took comfort in the fact that the 30-day SEC yield for MUB, a very similar ETF, was 2.16% on the same day. Other types of yield had substantial differences.)  For a taxpayer with a marginal tax rate (MTR) of 24% (the 24% “tax bracket”), the calculation would be as follows:

     2.17% / (1 - .24)                 =               2.86%

On the same day, the 30-day yield for the comparable corporate bond fund, SPIB, was 3.32%. Therefore, it would be fair to conclude that the municipal bond market is not priced attractively for taxpayers in the 24% tax bracket. 

Another way to come at this would be to ask, just how high would the marginal tax rate have to be to for muni bonds to be attractive today?  A little algebraic manipulation gives the following formula:

     1 – (Tax Exempt Yield / Tax Equivalent Yield)         =            Break-Even Marginal Tax Rate

Using the same yield figures as above gives the following results:

     1 – (2.17% / 3.32% )           =           35%

So, based on recent yields, only taxpayers in the 35% bracket or above will find municipal bonds to be an attractive investment. From the 2022 tax brackets table above, a single taxpayer would have to have a taxable income of $215,950, and a married taxpayer filing jointly more than $431,900, to be in the 35% or above tax bracket. Importantly, most taxpayers these days use the standard deduction, which reduces their income by $12,950 for single filers and by $25,900 for married filers. In other words, the gross taxable income required to be in the 35% tax bracket in 2022 is $228,900 for single filers and $457,800 for married filers. 

Of course, as noted above, the municipal bond market is less risky (from a credit standpoint) than the corporate bond market, so some allowance for that fact should be made. For example, for taxpayers in the next lower bracket of 32% who may be inclined to invest in municipal bonds, how much lower would the corporate bond market’s yield have to go before muni bonds became attractive for those taxpayers?

Using the same formula for the taxable equivalent yield with a 32% marginal tax rate gives the following results:  

      2.17% / (1 - .32)                =                3.19%          

To make municipal bonds attractive to taxpayers in the 32% bracket, the comparable corporate bond yield would have to be below 3.19%. That is only .13% lower than the actual 30-day SEC yield on the benchmark corporate bond fund of 3.32%. Pretty close. Perhaps close enough to make muni bonds marginally attractive for those 32% MTR taxpayers.  

However, the jump down to the next lowest tax bracket, 24%, is quite large. Above we showed that the corporate bond benchmark’s 30-day SEC yield would have to be below 2.86% to make muni bonds attractive to those in the 24% tax bracket. That’s a gap of .46% compared to the actual corporate bond market yield. In the bond world, that is a huge spread. 

As a rule of thumb, I tell clients that municipal bonds are unlikely to be attractive for those below the top three tax brackets because the jump from a MTR of 24% to a MTR of 32% is so large mathematically.  

Yield-to-Worst

Although I have emphasized the importance of using only 30-day SEC yields to compare bond funds, I have not found a good source for that data historically. (At least, not one that I can access without an expensive subscription.) 

However, I might like to know whether today’s muni bonds are more or less attractive than average compared to corporate bonds from a historical standpoint. Although my database, FactSet, provides only a very limited history of 30-day SEC yields, they do provide historical yield-to-worst data on the underlying indexes. Since both benchmark ETFs are passively managed relative to their indexes, their portfolios should be very index-like, so it is fair to use the historical characteristics of the underlying index to approximate the historical characteristics of the funds. 

Yield-to-worst is a common yield measure for callable bonds. Treasury bonds are not callable, so for them, yield-to-worst is equal to yield-to-maturity, a calculation that assumes that all interest payments are reinvested in the bond, and that the bond is held to maturity, at which time it repays the par value. Yield-to-worst assumes that every bond is called at the earliest opportunity. Issuers only exercise their call rights when doing so is economically advantageous to them, usually because interest rates have fallen. This makes exercising the call unattractive for investors, since they have to give up a higher-yielding bond and can only replace it with a lower-yielding bond. It has the effect of dampening down the yield calculation relative to yield-to-maturity. Some corporate bonds are callable, and most municipal bonds are callable, which is why it is vitally important to use yield-to-worst for these bonds and not yield-to-maturity. 

Tactical Rich/Cheap Analysis

Yield-to-worst is only a rough approximation for the 30-day SEC yield. However, for the purpose of illustrating the tactical richness or cheapness of municipal bonds, it is probably close enough. To make an apples-to-apples yield-to-worst (YTW) comparison of munis and corporates requires an assumption about the marginal tax rate. Since we have already shown that, at least at present, municipal bonds are priced to be marginally attractive for taxpayers in the 35% bracket, I will use 35% as my MTR assumption. 

To adjust taxable (Treasury and corporate) bond yields to after-tax yields simply involves subtracting 35% of the yield. 

From a tactical standpoint, there have been times when municipal bonds were priced to have a much higher after-tax yield compared to corporates than they do today. For example, it appears that the “taper tantrum” of 2013 had a more pronounced effect on municipal bonds than Treasurys or corporates. Municipal bonds have a largely retail ownership, and such events may tend to spook retail investors more than institutional investors.   

We have shown above that the breakeven marginal tax rate is given by the ratio of muni yield to corporate yield. That is, it is not the spread between the two that is critical, rather, it is the ratio between the two. The graph below shows the history of that ratio.

At present, the yield-to-worst yield relationship between the national muni benchmark (VTEB) and the corporate benchmark (SPIB) is right at its trailing 60-month average. It was at a trough of 54% at the end of 2021. File that observation under “missed opportunities.”  It would have been a good tactical move to shift out of munis and into corporates at that time.

State Muni Funds 

We have only been analyzing the attraction of national municipal bonds using federal income tax rates because municipal bonds are exempt from federal income taxes. Most states also tax bond interest income. However, most states do not tax interest on municipal bonds issued by municipalities within their own state, including bonds issued by the state itself. Investors in states with high tax rates, such as California, New Jersey, and New York, often find it most attractive to invest in municipal bonds or bond funds that focus on their state. If you are in a high-tax state, you may find that investing in a fund focused on your state will be slightly more attractive, although that introduces some amount of concentration risk. 

New Jersey is one of the states with the highest income tax rates, so investing in a New Jersey muni fund may be attractive for New Jersey residents. I have written about New Jersey muni bond funds here.

We here in Pennsylvania are fortunate to have the lowest flat income tax rate in the U.S. of only 3.07% . That means that it is not as attractive to invest in a single-state muni for PA taxpayers. However, a little extra tax savings doesn’t hurt either! I have written about PA muni bond fund here. 

Closed-End Muni Funds  

Another possible way to invest in municipal bonds is through a muni bond closed-end fund. Closed-end funds (CEFs) are mutual funds that have a fixed number of shares and trade during the day on exchanges like stocks. They differ from open-end mutual funds that are bought and sold in direct transactions with the fund company at the fund’s net asset value (NAV)—the value of the underlying portfolio. In this respect, they are similar to ETFs. However, because ETFs can easily increase or decrease shares outstanding, ETFs trade at prices very close to NAV. Closed-end funds often trade at prices that differ from NAV by a substantial amount—usually at a discount.   

In addition to trading at prices that may differ from NAV, closed-end funds also differ from open-end funds and ETFs in that closed-end funds may utilize a limited amount of leverage. The average amount of leverage among closed-end funds utilizing structural leverage is about 33%. Structural leverage increases the amount of assets owned by the fund. For example, a $100 investment in a closed-end fund with 40% structural leverage will have a portfolio of $140 in assets and $40 in debt. 

Because institutions such as closed-end funds can borrow at much lower interest rates than individuals, owning closed-end funds is an economically attractive way for individual investors to obtain leverage. As long as the rate paid on the debt is lower than the return on the assets purchased with the debt, the fund will enhance its return with leverage. If the opposite is the case, the fund will magnify its losses. The use of debt increases the risk of a closed-end fund, but in a controlled and rational way. About two-thirds of closed end funds utilize some form of debt. It is more common for bond funds to use debt and less common for equity funds.

The table below shows a few national muni closed-end funds which have attractively high discounts to their NAVs and also attractively high distribution yields. They all have substantial amounts of leverage, which has worked against them in recent months as interest rates have increased. 

Indeed, as shown in the graph below, the recent extremely adverse performance of closed-end municipal bond funds has caused their largely retail owners to stampede for the exits. This is typical behavior for retail investors, and it is most clearly reflected in the changes in the average NAV discounts of the funds. In 2021, retail investors couldn’t buy enough closed-end muni funds, amid the political talk of raising income taxes on “the rich.”  In August of 2021, the average national muni closed-end fund actually traded at a premium of 1.4%!  Now, the average discount is well above its trailing 60-month average, as shown in the graph below.

Closed-end funds are actively managed, and therefore they have higher expense ratios than those of ETFs. Some analysts would argue that because of the inefficiencies inherent in the municipal bond market, it is helpful to pay for active management to exploit those inefficiencies. At some point, the discounts to NAV become large enough to offset the negative of higher expense ratios. We appear to be approaching such a point. Consequently, if you are going to own municipal bond funds, now might be a good time to own them through closed-end funds rather than either open-end mutual funds or ETFs. Yes, the discounts could get wider, but it may be time to shift towards CEFs. 

Conclusion

• Municipal bonds are attractive after-tax investments for those in higher tax brackets. 
• They do a better job of diversifying stock risk than corporate bonds (that is, they have a lower correlation with stocks).
• 30-day SEC yield is the best measure to compare muni yield with corporate bond yield.
• To control for interest rate risk, compare funds with the same duration (or close).
• The ratio of muni yield to corporate yield will give you the break-even marginal tax rate (MTR) for munis to be attractive.
• Right now, the breakeven MTR is about 35%.
• Late 2021 would have been a good time to switch out of munis and into corporates.
• Now the relationship between corporates and munis is about average.
• Closed-end muni bond funds have become unusually cheap and may be the best way to own muni bonds at present.