With election-year proposals to raise income and capital gains taxes once again making headlines, many investors are thinking about adding federally tax-free municipal bonds to their portfolios.
Munis have long been popular with investors who seek reliable income, low credit risk and exemption from federal taxes on the income the bonds pay. Their prices have been surging so far this year as provisions of the 2017 Tax Cuts and Jobs Act are set to expire at the end of 2025 and proposals for new taxes and spending bloom in Washington like the cherry trees around the Tidal Basin.
For certain investors in high tax brackets, the after-tax return on munis held in taxable accounts are already attractive relative to taxable bonds. And their appeal could increase if federal tax rates do rise.
But while seeking munis as a bulwark against the threat of rising taxes may seem like an easy decision, there are things you need to know first. Elizah McLaughlin, who manages the Fidelity® Municipal Income Fund (FHIGX), points out that gaining entry to the muni market can be tricky as supply and demand are often out of alignment. That’s because the supply of new and existing bonds for sale does not change as quickly as the demand for them and prices may change unexpectedly. “Now everybody wants munis because there’s a lot of uncertainty and that’s pushed prices up,” she says.
McLaughlin also points out a number of unknowns that could have an impact on would-be muni investors in the months ahead. “Investors need to be aware that the price of bonds is not going to be determined just by what happens with the tax code,” she says. “There are other things that are going to drive market performance and that may cause muni bonds to fall in price.”
Rates and duration
Perhaps the most significant of those “other things” is uncertainty about the direction of monetary policy set by the Federal Reserve. The Fed has indicated that it is planning to lower interest rates but could also keep them higher for longer as a way to keep inflation at bay if economic growth continues. Bond prices and interest rates typically move in opposite directions so falling rates would likely raise muni bond prices overall.
Not all bonds are equally sensitive to changes in rates, however. Those with greater sensitivity to rate changes are described by bond experts as having longer duration, while those with less sensitivity are said to have shorter duration. Duration is an important concept for anyone investing in bonds to consider as they build a portfolio of individual bonds or buy shares in a bond mutual fund or ETF.
McLaughlin says that with changing rates possible, managing duration is important. “If rates fall uniformly across the yield curve, the longest duration funds could outperform, all else being equal. Bond prices rise as rates fall, so bond funds that are most sensitive to rate changes could see their net asset values increase the most, she says. "If rates only decline on the short or intermediate parts of the curve, funds with the most duration in that part of the curve could do best."
Consider credit risk
For bond investors, the risk that an issuer might default is always a concern and another appeal of munis is the low risk of default by issuers who have the ability to raise taxes if necessary. Over the past 3 years, the federal government has transferred large amounts of money to municipal governments. These bailouts have improved the fiscal health of many muni bond issuers and lowered the risks of default that had been a concern as COVID-related shutdowns of business activity cut into local tax revenues in many places. Even the state of Illinois, which had teetered on the edge of a downgrade to a sub-investment credit rating has seen its credit rating improve this year despite a lack of fiscal reforms. Improved credit quality adds to the appeal of an asset class that has historically had one of the lowest default rates of any category of bonds. From 1970 to 2018, according to Moody’s Investor Services, 0.10% of muni bonds defaulted. Meanwhile, the average cumulative default rate for US corporate bonds was 2.28%, almost 23 times higher. Of course, past performance is no guarantee of future results.
However, it’s important to be aware that not all muni bonds are enjoying lower credit risk. McLaughlin points to health care, private higher education, and project finance as areas where not all issuers are in equally good financial health and says that her team relies on robust fundamental research to avoid unnecessarily risky bonds.
How to muni
Now that you know to look out for rising rates and lower credit quality, you should consider the pros and cons of the various ways of getting muni exposure. If you are looking for tax shelter and attractive returns consider muni bonds or bond funds with high credit quality and intermediate durations.
But careful research is key. Unlike stocks, muni bonds are not traded on centralized exchanges. Instead, the muni bond market is fragmented, opaque, and relatively illiquid compared with other financial markets. While stocks can be easily and directly purchased by most anyone, many newly issued muni bonds are reserved for purchase by a handful of large asset management firms, which in turn make them available to individual investors either through mutual funds or for individual purchases. In addition, because muni bonds are most appealing to taxpayers living in the states where the bonds are issued, the pool of investors who may want to buy and sell them at any given time may be smaller than would be the case for other types of investments that appeal to a global market.
Despite these caveats, municipal bonds are widely held among individual investors, who account for roughly 70% of the market, a far higher percentage than is the case for other types of bonds. If you want to join them, you can get exposure to taxable municipal bonds through investing in mutual funds and ETFs, or by buying individual bonds. Or if you want to combine ownership of individual bonds with professional management you can consider a separately managed account (SMA). Whichever approach you choose, keep in mind that tax-free interest is only a benefit if your bonds are held in a taxable account, rather than an IRA.