Based on historical measures, tax exempt municipal bonds are rich to just about every other fixed income asset class!
The three examples below illustrate how tax exempt municipal bond yields compare to taxable alternatives.
Proof: (All Data as of 4/23/2021)
1. AAA Tax Exempt Municipal Bonds vs Treasuries
| Fixed Income Asset Class | 1 Year | 5 Year | 10 Year | 30 Year |
| AAA General Obligation Tax Exempt Municipal Bond Yield Estimate | 0.04% | 0.36% | 0.90% | 1.56% |
| Maturity Equivalent Treasury Security | 0.07% | 0.83% | 1.58% | 2.25% |
| Difference | 0.03% | 0.47% | 0.67% | 0.69% |
| Implied Federal Marginal Income Tax Rate | 42.9% | 56.6% | 42.4% | 30.7% |
a) Source: Bloomberg BVAL1 Estimates, U.S. Department of the Treasury
b) The interest from Treasury bills, notes and bonds is taxable at the federal level, but not the state and local level
c) 2021 top marginal income tax rate 37%
d) Biden administration proposed top marginal income tax rate 39.6%
2. AA Tax Exempt Municipal Bonds vs. Taxable Municipal Bonds
| Fixed Income Asset Class | 1 Year | 5 Year | 10 Year | 30 Year |
| US General Obligation AA Tax Exempt Municipal Bond BVAL Yield Estimate | 0.143% | 0.542% | 1.152% | 1.799% |
| US Taxable AA+, AA, AA- Municipal BVAL Yield Estimate | 0.268% | 1.058% | 1.958% | 2.849% |
| Difference | 0.125% | 0.516% | 0.806% | 1.05% |
| Implied Federal Marginal Income Tax Rate | 46.6% | 48.8% | 41.2% | 36.9% |
a) Source: Bloomberg BVAL1 Estimates
b) 2021 top marginal income tax rate 37%
c) Biden administration proposed top marginal income tax rate 39.6%
3. AA Tax Exempt Municipal Bonds vs. Corporates
| Fixed Income Asset Class | 1 Year | 5 Year | 10 Year | 30 Year |
| US General Obligation AA Tax Exempt Municipal Bond BVAL Yield Estimate | 0.14% | 0.54% | 1.15% | 1.80% |
| USD US Corporate AA+, AA, AA- BVAL Yield Estimate | 0.21% | 1.08% | 2.10% | 3.0135 |
| Difference | 0.07% | 0.54% | 0.95% | 1.21% |
| Implied Federal Marginal Income Tax Rate | 32.5% | 49.8% | 45.2% | 40.3% |
a) Source: Bloomberg BVAL1 Estimates
b) 2021 top marginal income tax rate 37%
c) Biden administration proposed top marginal income tax rate 39.6%
Conclusion
Taxable municipal bonds appear to provide a very attractive after-tax income stream to investors (remember it’s not what you earn but what you keep that matters).
Why does this anomaly exist?
1. Demand is outstripping supply.
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ICI (Investment Company Institute) data2 show that since May 2020, investors have piled a monthly average of $8.4B into municipal bond mutual funds and $1.8B into municipal bond ETFs.
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What are the drivers of this investment surge? 1) fear of rising taxes (but when does fear overpower the numbers?) and 2) the SALT cap makes tax free municipal income attractive because the cap raises investors effective tax rate. There are proposals before Congress to adjust or eliminate the SALT deduction limitation.
2. Supply of tax exempt municipal bonds has been reduced due to COVID 19 and the inability of municipal bond issuers to advance refund higher cost debt with tax exempt municipal bonds (a process very similar to how homeowners refinance their mortgages). There are proposals before Congress to change this too.
3. The municipal market typically sees a period of underperformance around tax day, usually April 15, as investors sell their mutual funds and ETFs to pay their taxes. This year, due to COVID 19, tax payments have been delayed to May 17. If 2021 is like years past, the municipal bond market may weaken around this date. As Barron’s April 22, 2021 headline reads, “Why the Muni Bond Market Could See a Correction Soon3”
We think you will get a better opportunity to establish new tax exempt municipal bond positions, perhaps as soon as tax day 2021 – May 17.