Should You Own Taxable Municipal Bonds?

Municipal bonds are not a sexy investment but they have historically offered some of the best returns available in the low risk investment product marketplace.

There is an estimated $4 trillion worth of municipal bonds outstanding. Thus, municipal bonds make up ~10% of the entire U.S. bond market.

The vast majority of these bonds are tax free but there is an estimated $840 billion of taxable municipal bonds outstanding. This part of the municipal bond market is not often discussed but offers one way for investors (even those in low income tax brackets) to improve upon a standard 60/40 portfolio.

In last week’s post How To Beat A 60/40 Portfolio I noted how taking credit risk which is different from standard broad fixed income indexes has the opportunity to provide better risk adjusted return. Municipal bonds offer an excellent opportunity to take very little credit while earning a significant credit risk premium.

To get a sense for the investment case for tax free municipal bonds consider one of the largest municipal bond ETFs the iShares National Muni ETF (MUB) which currently has a weighted average yield to maturity of 3.2% and weighted average maturity of 6.2 years. Comparably, a 7 year U.S. Treasury bond currently offers a yield to maturity of 3.94%. Thus, given the fact that U.S. Treasury bonds are generally viewed as safer tax free municipal bonds are not attractive before the tax advantage is considered. However, tax free municipal investments become much more appealing once accounting for the tax advantage.

Assuming an investor is in the highest federal tax bracket, currently 37%, the tax equivalent yield on MUB is 5.1%. Thus, on a tax equivalent basis municipal bonds are currently offerings 1.15% of spread vs similar maturity treasury bonds. To get a sense for how safe municipal bonds are consider the fact that the historical default rate is just ~0.08%. Thus this level of spread is highly attractive compared to the historical level of risk.

To get a sense of how significant this 1.15% spread is consider that high grade corporate bonds, which can be proxied with the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) currently offer a spread of ~1% vs similar maturity treasuries. To get a sense of how much credit risk investors are taking with LQD vs high grade municipals funds such as MUB it is relevant to consider relative credit ratings.

LQD has ~8% exposure to AA or better rated bonds, ~46% exposure to A rated bonds, and a ~46% exposure to BBB rated bonds. Comparably, MUB has ~84% exposure to AA or better rated bonds, ~ 59% exposure to A rated bonds, and less than 1% exposure to bond rated BBB or lower. Thus, the key takeaway here is that by owning tax free municipal bonds investors in high tax brackets are able to earn a fairly significant credit risk premium while taking very little credit risk.

This setup can make municipal bonds an attractive investment for individual in high income tax brackets. However, the investment opportunity is not limited only to those in high tax brackets.

Taxable municipal bonds provide an excellent way for low tax bracket investors or investors investing in a tax advantaged account structure (such as an IRA) to benefit from municipal bonds.

One way to efficiently access the taxable municipal bond market is through the Invesco Taxable Municipal Bond ETF (BAB). Currently, BAB offers a weighted average yield to maturity of 5.1% and an effective duration of ~8 years. Comparably, the iShares 7-10 Year Treasury Bond ETF (IEI) offers a weighted average yield to maturity of 3.92% and an effective duration of ~7.4 years. Thus, investors in BAB are able to earn a credit risk premium of ~1.18%. The credit profile for BAB is similar to the previously mentioned MUB. Moreover, BAB also offers substantially more credit risk premium than broader bond market index funds such as the iShares Core U.S. Aggregate Bond ETF (AGG) which currently offers a average yield to maturity of 4.6% and has an effective duration of 6.2 years.

As shown by the chart below, BAB has substantially outperformed both AGG and IEF since its inception in 2009. Since inception, BAB has delivered a total return of 94.4% compared to a total return of 38.8% and 35.6% delivered by IEF and AGG respectively.

BAB has also outperformed on a risk adjusted basis. As shown by the chart below, BAB has realized an average trailing 3 year sharpe ratio of 0.71 compared to a sharpe of 0.62 and 0.39 realized by AGG and IEF respectively.

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