One in every of the largest draws to the municipal bond market is their tax-free status. Issued by states and native governments, Uncle Sam cuts muni investors a break and allows their interest payments to be tax-free. And in lots of cases, also they are exempt from state and native taxes. As such, municipal bonds are sometimes a well-liked selection for taxable accounts and high-income individuals.

Nevertheless, not all municipal bonds are the identical.

There’s a growing ecosystem of taxable municipal bonds. While this will seem counterintuitive, these taxable munis offer quite a lot of advantages to investors, including increased income and reduced portfolio risk. In lots of cases, taxable munis may very well be a greater buy than corporate bonds with similar durations. With that in mind, taxable munis may very well be a terrific addition to a fixed-income portfolio.

Wait, My Muni Is Taxable?

The hallmark of municipal bonds has been their tax-free yields. Since 1913, municipal bondholders have enjoyed coupon payments free from federal income taxes. This tax exemption was designed to assist state and native governments enjoy a lower cost of capital for his or her funding and borrowing needs. Moreover, states and native governments often offer tax breaks to their residents for these munis.

With this in mind, municipal bonds have long been portfolio holdings for a lot of high-net-worth families, insurance firms and institutional investors. Nevertheless, lately, regular and lower-income earners have also befited from the high taxable-equivalent yields and robust credit quality offered by munis of their portfolios.

It’s strange to think that there’s a growing portfolio of fully taxable assets within the $4 trillion muni market.

Starting within the mid-Nineteen Eighties, the federal government restricted the kinds of projects state governments could fund with tax-free municipal bonds. It wasn’t until 2009 that taxable munis took off, due to the American Recovery and Reinvestment Act and the Construct America Bond program. The Tax Cuts & Job Act of 2017 included laws that prohibited municipalities from issuing tax-free bonds for debt restructuring, shifting these pre-refunding transactions onto the taxable side.
All of this created an enormous marketplace for taxable municipal bonds.

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What’s the Point?

For a lot of investors and financial advisors, the considered “what’s the purpose?” may very well be going through their heads. In any case, the appeal of munis is that tax-free interest. Why mess with taxable munis in the primary place? How do higher returns, higher yields and a probability to de-risk a fixed-income portfolio sound?

First, let’s discuss taxable muni bonds with strong income potential. Tax-free munis often have low yields due to the tax break, producing a taxable equivalent yield after factoring in taxes. But, because they don’t offer such a break, taxable munis often pay higher yields. Actually, on average, taxable munis pay rates above investment-grade corporate bonds because they’re less popular and face pricing inefficiencies, allowing investors to potentially secure higher yields. Also, taxable doesn’t necessarily mean fully taxable. Interest from a taxable muni is federally taxable, many states don’t impose additional taxes. So, in the event you’re a resident of California and you buy a state-issued taxable muni, you’ll owe federal taxes but not California state income tax, which might further enhance yields.

Those higher yields have provided taxable munis with some very strong total returns, outperforming other investment-grade bonds during the last decade. This chart from Latest York Life shows that taxable munis have beaten IG corporates, the broader bond market, Treasuries and MBS bonds. As for traditional tax-free munis? Taxable munis have beaten them as well by a mean of two% per yr over the identical period.

 
Source: Latest York Life

Perhaps probably the most interesting piece is that taxable munis are less dangerous than corporate bonds for that higher yield.

Simply because they’re taxable doesn’t mean they’re someway backed in a different way than tax-free municipal bonds. Many are backed by a state’s taxing authority or the revenues generated by a particular project. For this reason, taxable munis have had very low default rates, similar to traditional bread-and-butter municipal bonds.

For this reason, more taxable munis carry higher crediting rankings. In line with Latest York Life, 77% of taxable municipal bonds are rated AA or higher in comparison with just 9% of worldwide investment-grade corporate bonds. Furthermore, taxable munis have experienced far lower rating volatility.

This higher rating, low default rate and lower volatility of rating changes allow investors to de-risk their fixed-income portfolios while getting a high yield. Switching out some corporate bond exposure for taxable munis can reduce a bond portfolio’s risk profile. It is a huge win for conservative investors and people near or in retirement.

Taking a Taxable Muni Approach

With the advantages of taxable munis and the power to de-risk a bond portfolio while still providing a high yield, investors will probably want to consider these bonds. Perhaps the one problem comes all the way down to getting your hands on taxable munis. Already, buying individual muni bonds is tough. Given the small size of the taxable muni segment, buying individual issues is almost inconceivable.

Which suggests we’re taking a look at funds — and even here, this might prove difficult.

There is simply one ETF that covers the sector, the $1 billion Invesco Taxable Municipal Bond ETF (BAB). It tracks the ICE BofAML U.S. Taxable Municipal Securities Plus Index, which holds various taxable muni debt, akin to Construct America Bonds and other refinanced debt. For many investors seeking to add a dose of taxable munis, that is the perfect technique to go.

There are a couple of closed-end funds (CEFs) covering the sector. CEFs are quirky, but investors may have the opportunity to get larger yields and discounts to the fund’s underlying NAVs with smart trading and timed buys.

Taxable Muni Bonds ETFs

These funds were chosen based on their exposure to the taxable municipal and Construct America bond sectors. They’re sorted by their YTD total returns, which range from -2.3% to 2.3%. They’ve expenses between 0.28% and a couple of.63% and assets under management between $367M and $1.53B. They’re currently yielding between 4.1% and 10.05%.

Taxable municipal bonds are sometimes missed within the fixed-income space, but they provide strong credit quality, high yields and higher total returns. They could be a terrific technique to de-risk a bond portfolio and boost income. While the choices so as to add them are limited, they feature robust assets and substantial trading volumes.

Bottom Line

Not all municipal bonds are tax-free, but that shouldn’t dissuade investors. Taxable munis have the potential to supply greater advantages and income than their tax-exempt counterparts. For investors, incorporating them right into a bond portfolio might help reduce risks and enhance income potential.