Fixed-income investing has become more popular in recent months due to the significant increase in yields, with U.S. Treasuries now trading between 4% and 5%. This rise in yields has also affected other high-quality fixed-income assets like municipal bonds and corporate bonds, which are now offering yields not seen in years. As a result, there is a growing demand for fixed-income securities in the market.
A Morningstar report revealed that the only investment category that saw positive fund inflows in 2023 was fixed income, which added $395 billion to bond funds. Specifically within the municipal bond market, the Investment Company Institute reported a significant flow of $8.35 billion into municipal bond mutual funds and ETFs during the first 10 weeks of the year. This influx of capital has benefited the municipal bond market, with the Bloomberg Municipal Bond Index posting a total return of -0.22% as of March 22, outperforming the Bloomberg Treasury Index (-1.18%) and the Bloomberg Corporate Bond Index (-0.65%).
One of the main advantages of municipal bonds over taxable bonds is the tax-free income they provide. Due to this tax advantage, municipal bond yields tend to be lower than comparable taxable bonds. For investors in the highest tax brackets, the tax-equivalent yield of municipal bonds can make them an appealing option. However, with yields on municipal bonds declining due to their recent out-performance, some investors may find it more beneficial to invest in taxable bonds, like Treasuries, particularly when considering after-tax yields.
Investors can compare the relative value of municipal bonds to taxable bonds using the AAA muni-to-Treasury yield ratio, which calculates the yield to worst of AAA-rated municipal bonds divided by the yield on comparable Treasuries. When this ratio falls below a certain threshold, investors in the highest tax brackets may find Treasury bonds to be a better alternative. Additionally, corporate bonds should also be considered as an alternative, especially for those paying state income tax.
When comparing corporate bonds to municipal bonds, investors should consider factors such as maturity, duration, liquidity, bond structure, and credit review. Credit agency ratings are important, but should not be the only factors considered. The after-tax yield on the Bloomberg Intermediate Corporate Bond Index is currently higher than the yield on the Bloomberg Municipal 1-10 Year Blend Index, even when factoring in moderate state income tax rates. This makes certain corporate bonds a potential attractive option for investors.
In conclusion, investors in the municipal bond market should proceed with caution, as some AAA-rated municipal bonds may be overvalued based on the muni-to-Treasury yield ratio. The traditional approach of exclusively investing in municipal bonds for high-net-worth investors should be reevaluated. It is essential for investors to review their investments on an after-tax basis, taking into account their specific tax situation, to make informed decisions and capitalize on current market opportunities in the fixed-income sector.