This commentary was originally sent to MFA clients on 02.02.2016
Due to the low interest rate environment of the past few years, municipal bonds have not been particularly attractive from a relative risk standpoint. However, it is something that we continually watch and consider. We hope that the below will help shed some light on our approach. Non-taxable municipal bonds typically have lower yields than taxable bonds, due to the income tax benefits of “muni bonds.”
Example: Assuming a 50% income tax rate, if a taxable bond yields 4%, then a non-taxable bond would only need to yield 2% to be competitive. It would have a “tax-equivalent yield” of 4%. Now lets assume that both bonds have a duration of 5 years. Put simply, this means that a 1% increase in interest rates would cause each bond to lose 5%. Both bonds would have an after-tax yield of 2% too. If each bond had a 5% price decline and 2% of interest, then the total return of each would be -3%. All else being equal, we would have no preference between a taxable and non-taxable bond. However, all else is not equal. Municipal bonds are extremely illiquid and their maturities are usually longer, which means more interest rate risk. Our goal is not to minimize taxes, but to maximize after-tax returns. These may seem similar on the surface, but one envisions returns as a zero-sum game, while the latter accepts the possibility that the returns pie may not be a fixed size.
With most interest rates at extremely low levels, we do not currently see much (if any) benefit to utilizing non-taxable municipal bonds. Muni yields and “tax-equivalent yields” do not offer any additional interest rate protection. Should interest rates and yields increase enough, then it would make a lot more sense to begin including municipal bonds in taxable portfolios. It is impossible to say if or when this will occur, but it bears watching and it is worth having a game plan in place for when that time comes.