By Evan Ratnow & Brian Haynes, Strategy Head, Third-Party Fixed Income, Traditional Investments & Analyst, Third-Party Fixed Income, Traditional Investments
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Taxable munis are not as widely known as their tax-exempt counterparts.
Most US investors are familiar with traditional tax-exempt municipal bonds.* But many may be less aware that state and local municipalities commonly issue taxable bonds too. We believe that this lack of awareness may create a potential opportunity.
The taxable municipal market was borne out of the Federal Tax Reform Act of 1986, part of which precluded municipalities from issuing in the tax-exempt market for certain purposes. These include the development or maintenance of sports facilities, pre-funding pension obligations, or where some of the proceeds of the bond issuance might benefit a private entity or business. From a credit perspective, there is no distinction between a taxable municipal bond and a tax-exempt municipal bond. For example, a general obligation bond of the State of New York has the same credit backing whether it is issued in the taxable or tax-exempt market.
In 2015, the taxable municipal market accounted for some 5% of the approximate US$400 billion total issuance in the US municipal bond market. However, there was a big surge in taxable municipal issuance in 2009-2010 owing to the creation of the Build America Bonds (BABs) program as part of the American Recovery and Reinvestment Act of 2009i. While BABs increased the overall size of the market, it is worth noting that the taxable municipal market was in existence well before the BABs program.
In our opinion, the small size of the market may act as a barrier to entry to larger asset managers. As a result, there may be a yield premium associated with this potentially under-followed market, which smaller, ‘boutique’ asset managers may seek.
Historically, municipal bonds – or ‘munis’ – have offered yields in line with those on other investment grade assets, such as investment grade (IG) corporates. They also appear to be of higher credit quality when we compare their credit ratings compared to those of IG corporates. As of 31 July 2016, the Barclays Intermediate Taxable Municipal Bond index had an average credit rating of AA2 against A3 for the Barclays Intermediate US Corporate Bond Index – Bond Rating Equivalence table below. This may explain the lower historical default rate for taxable munis compared to corporate bonds as well - figure 1.
Figure 1: Fewer defaults in taxable munis
Source: Moody’s Investor Services, as of December 2015
Taxable munis may also offer an attractive risk/return profile. Over time, taxable munis have delivered similar returns to IG corporates but with less volatility. Furthermore, returns-based analysis suggests that taxable munis may offer greater potential downside protection than corporates. In the ten-year period to end-June 2016, the Barclays Intermediate Taxable Municipal Index saw a maximum peak-to-trough decline or drawdown of 3.9%, compared to a 13.4% drawdown for the Barclays Intermediate Corporate Bond Index.ii Using the same indices, taxable munis experienced slightly less downside volatility than corporate bonds.
Of course, taxable munis do come with risks. As with various other fixed income sectors, they have experienced reduced liquidity since 2008. The relatively small size of this market may further constrain market liquidity. Investors should also understand that bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline.
The taxable municipal bond market may be a relatively attractive sub-asset class compared to other IG areas of the market and may provide investors with a differentiated source of yield. Given the risks inherent in this market, specifically liquidity and credit risk, as suitable we believe investors may want to consider allocating to this asset class via an active manager with both experience of investing in the sector and dedicated resources to perform the necessary credit research.
* Tax-exempt municipal bonds’ yields only accrue tax-free to US income-tax payers.
1. The ratings from Aa to Ca by Moody’s may be modified by the addition of a 1, 2, or 3 to show relative standing within the category.
2. The ratings from AA to CC by Standard and Poor’s and Fitch Ratings may be modified by the addition of a plus or a minus to show relative standing within the category.
This material does not constitute an offer to sell or the solicitation of an offer to buy these securities. Views, opinions and estimates expressed herein may differ from the opinions expressed by other Citi businesses or affiliates, and are not intended to be a forecast of future events, a guarantee of future results, or investment advice, and are subject to change without notice based on market and other conditions.
High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made. Depending on your state of residency, some bond interest may be exempt from state and local taxes; however, interest may be subject to the federal alternative minimum tax
An Investment in Municipal Bonds may be subject to state and local taxes and you may also be subject to Alternative Minimum Tax (AMT). Official offerings may be made only by the final Official Statement. If sold prior to maturity you may receive more or less than your original investment. Past performance is not a guarantee of future results.
iWasmer, Schroeder & Company, January 2016
iiBloomberg, as of 30 September 2016