Capitalizing on opportunities in the municipal bond market

“The rise in bond yields over the past two years has made tax-exempt municipal bonds a very attractive asset class, especially for higher-income earners,” said Nathan Will, JD, Vanguard head of municipal credit research. “And for active fund managers, the fragmented nature of the muni market, the additional complexity that comes with call options, and the challenge of assessing credit risk provide opportunities to potentially deliver even better-than-market returns.”

Muni yields are at compelling levels

“With municipal bond yields rising alongside those of U.S. Treasuries, current levels offer compelling value from a historical perspective,” said Will. “And higher yields make the draw of tax-exempt munis even greater.”

When muni yields are low—say, 1%—the additional after-tax yield earned thanks to the federal tax exemption is just 0.69 percentage points for investors in the top federal income tax bracket—currently 37% at the federal level plus a 3.8% Medicare surtax. For comparison, the yield that would be needed on an otherwise identical taxable bond to be equivalent—the “tax-equivalent yield”—would be 1.69%.

But when muni yields are at 4%, the additional after-tax yield earned by those same investors at the federal level is 2.76 percentage points. As such, the tax-equivalent yield would be 6.76%.

Investors may see even more tax savings at the state and local level. The map below displays tax-equivalent yields across the U.S. when taking only federal and state income tax exemptions into account.

Opportunities for active managers in munis beyond yield:

• The market is fragmented. Roughly 30,000 local government units recognized by the U.S. Census Bureau actively come to market to sell muni bonds. The result is a pool of over 1 million securities outstanding—three times the number in the corporate bond market. Most muni bonds are issued for local projects, which is why the majority of munis have an issuance size of less than $1 million.* 
  
  For active managers, the number of issuers and the diversity of projects being financed present plenty of opportunities to find relative value.

• Call options make interest rate risk less straightforward. The most common measurement of interest rate risk is duration, which is calculated in years and captures the sensitivity of a bond’s price to a change in interest rates. A duration of 7 years, for instance, means that a 1% rise in interest rates would cause the price of the bond to fall by approximately 7%; conversely, a 1% drop in rates would cause a bond’s price to rise by approximately 7%.
  
  However, most muni bonds have an embedded “call option,” which gives issuers the flexibility to redeem bonds ahead of their stated maturity. That option makes assessing interest rate risk more complex, as a bond’s duration changes with the probability of its call option being exercised.
  
  For active managers, skillfully navigating interest rate risk with callable bonds as interest rates evolve can help generate outperformance versus the broad muni market. (Here’s a deeper dive on muni call options.)

• Credit analysis has become more crucial—and challenging to assess. Muni bonds are generally regarded as high quality—in other words, their risk of default is very low. Compared with corporate bonds, a much greater share of muni bonds are investment grade, meaning they are rated BBB– or higher by rating agencies.
  
  Even so, munis’ credit profile has evolved significantly since the 2008 global financial crisis (GFC). Before the GFC, specialized insurance companies guaranteed the majority of bonds issued, conferring their AAA ratings to bonds and commoditizing much of the market. As illustrated in the chart below, those insurers pulled back after heavy losses during the GFC. The percentage of bonds rated AAA in the Bloomberg U.S. Municipal Bond Index fell from close to 70% pre-crisis to around 15% post-crisis.
  
  For active managers supported by a team of analysts with deep expertise and broad experience, the renewed need for careful, bond-by-bond credit analysis presents another opportunity to add value by sidestepping bonds that might underperform.

The takeaway

“In the U.S., muni bonds tend to provide the highest after-tax risk-adjusted returns relative to other types of bonds for those in the highest tax bracket,” said Will. “Skilled portfolio managers—backed by a deep, experienced bench of credit analysts and traders—who can capitalize on the fragmented market, navigate interest rate risk, and conduct extensive credit analysis have the potential to deliver even better returns for investors who are comfortable with taking active risk.”

*Vanguard calculations based on Bloomberg data, as of April 17, 2023.

Related links:

• Active Fixed Income Perspectives
• Get targeted municipal exposure with low-cost Vanguard ETFs
• Building tax-efficient portfolios: Q&A with Justin Schwartz

Notes:

All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax. 

The information contained herein does not constitute tax advice, and cannot be used by any person to avoid tax penalties that may be imposed under the Internal Revenue Code. Each person should consult an independent tax advisor about their individual situation before investing in any security.