More importantly though, municipal bonds’ income proposition remains very compelling. Long-term muni yields are attractive relative to Treasuries before tax, and especially after tax. At March 9, we had a 30-year muni yield of 3.1% vs. 2.8% on a 30-year Treasury. Pretty good. But factor in munis’ tax exemption, and that’s a 5.5% taxable equivalent yield on a 30-year municipal bond (Assumes highest marginal tax rate of 39.6%, plus the 3.8% tax on investment income under the Affordable Care Act). Really good. It’s little surprise municipal bonds are attracting the attention of crossover buyers (i.e., taxable investors). We expect that crossover interest to continue, bolstering demand and supporting muni prices in 2015.
Market Realist – Municipal bonds are attractive in terms of tax-adjusted yields.
If you’re a short-term investor—with an investment horizon of less than three years—and belong to the 39.6% tax bracket, the effective yield for you on the 30-year municipal bond is 5.5%. The graph above shows the difference. The difference would be smaller if you belonged to a lower tax bracket. In that case, municipal bonds would be less attractive.
You can also compare the yield on the municipal bond with the after-tax yield on the Treasury (TLT), which is a paltry 1.6%, compared to the unadjusted municipal bond yield of 3.1%. Treasuries with shorter maturities (IEF)(SHY) would yield you even less, however. That’s because you’d be taking on less interest rate risk. You’ll find more on this topic later in this series.
Using one valuation method, the spread between municipal bonds and Treasuries is around 270 basis points. The spread is around 150 basis points if you use the other method. Keep in mind, though, that Treasury yields are usually low due to the safety they provide. There’s always a risk-to-return tradeoff. You can have higher a return only if you take on higher risk. However, municipal bond issuers’ fiscal strength is improving. Also, these bonds have hardly defaulted, historically, relative to corporate bonds (HYG)(JNK).