So as rates have declined for the past four decades most investors’ first thought is not “well my municipal tax haven just lost its luster”. As rates have fallen, so too has the value of the tax exemption investors endear when it comes to most municipal bonds. Below we will explore some of the ramifications of lower yields on the value of the exemption, why munis tend to lag in a rate rally and outperform as rates climb, potential benefits of munis during periods of market dislocations, and how we are viewing the value of the asset class in today’s environment.
The value of the tax exemption associated with municipal bonds is directly related to the prevailing yield. If your present tax rate is 40% and rates are at 4%, then the value of the exemption is 160bps- lots of value in the exemption there. Interestingly, this was the prevailing rate on 10yr munis coming into the GFC. Fast forward just over a half score later and while the tax rate is approximately the same, the muni yield has fallen to 1%, and thus, the value of the exemption has declined commensurately to 40bps.
So the value of the exemption falls as rates fall, and rises as they climb- this underscores our next point as why munis tend to lag in a rally and outperform during rising rate environments. After-tax yield parity, or yield equivalence, demonstrates this typical relationship well. Assume you have a taxable bond with a 4% yield and tax rates are 40%- all else equal you would be indifferent between this bond and a municipal at a 2.40% yield. We have yield equivalence. Now come closer to today’s yields and that same taxable bond has a 2% yield, our muni would likely be closer to 1.20%. So the taxable bond’s yield fell 200 basis points and the muni bond yield fell 120. Multiply this 80bp difference by 10yrs of duration and you have 8% return difference favoring the taxable bond. The taxable won as yields fell. Now if you reverse everything and go from today’s lower rates back to the higher rates used for the example, if the taxable yield were to climb by 200bps the muni yield need only increase by 120bps to maintain parity- thus the municipal bond would outperform in such a rising rate environment. This sums up to state that munis experience lower “empirical durations” than their taxable counterparts- empirical durations are a hot topic of discussion for this year’s summer BBQs. BBQ by the way is a potential teaser to my next post.
Mean reversion is a powerful tool in fixed income portfolio management- after all, absent a default, all bonds eventually mature or get tendered- or as one of our traders always says, “all bonds go to heaven”. As such, diversification and sector rotation remains one of the most important principals and tools in active management- as time always brings us closer to maturity, it is nearly impossible for a single fixed income asset class to win year-after-year. In fact, between municipals, corporates, and securitized sectors over the past dozen years, no sector has managed to string together more than two years as the top performing asset class- no three-peat 90’s Bulls in fixed income as maturity-mandated oscillation helps to ensure nothing stays too high or too low for too long. Amongst the three sectors noted above corporates and municipals have most frequently traded for the top spot on an after tax return basis, with securitized serving as the tried-and-true steady Eddie of the portfolio occupying the middle spot more than any other. Thus, even though the value of the tax exemption has fallen, municipals still offer great value within a diversified portfolio as fixed income asset classes tend to force mean reverting moves. The Eddie hyperlink above is to the page of IR+M’s own Steady Eddie, Ed Ingalls. If you have ever had the pleasure of talking to Ed, mean reversion is a frequent topic and an area of great knowledge.
So how do we view munis today? We still view the asset class as having value within a diversified portfolio. Munis have experienced exceptionally low default rates over the last half century highlighting credit stability within the sector. Munis will likely outperform in a rising rate environment should the economy pick up post-Covid or inflation tick higher as a product of multiple iterations of fiscal and monetary stimulus. And lastly is liquidity- diversification benefits are typically focused on and studied based on returns. Liquidity however can also vary greatly across asset classes contemporaneously. Municipal liquidity remained stronger than that of other investment grade fixed income classes during most of the credit spread widening environments of the last ten years and for this reason we view owning municipals as part of a diversified portfolio as an enhancement to overall portfolio liquidity. So while the tax haven might be worth less in a low yield environment, it is certainly not worthless.
