Gimme (tax) shelter

Here's what to think about if you're looking to munis to help offset higher taxes.

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Key takeaways

  • Many investors are seeking tax-free municipal bonds as proposals for higher taxes emerge from Washington.
  • Investors seeking to add munis should be aware of potential interest-rate and default risks as well as taxes.
  • Careful active management and rigorous credit research can help muni investors in an increasingly uncertain environment.
  • There are a variety of ways to get muni bond exposure.

Since proposals to raise income and capital gains taxes began circulating in Washington more than a year ago, many investors have been adding tax-free municipal bonds to their portfolios. So far this year, tax-free muni mutual funds and ETFs have attracted more than $88.5 billion, more new money than in any comparable time period in the past 25 years.

Munis have long been popular with investors who seek reliable tax-free income and low credit risk. Their prices had already been surging after the 2017 tax reform eliminated many federal tax deductions. Now, driving muni demand even higher, is the possibility that Congress could push up effective income tax rates for high-income residents of high-tax states as high as 50%. But that surging demand has pushed average yields below those of Treasurys and corporate bonds. Bond yields and prices move in opposite directions.

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 Fidelity© Municipal Income Fund (FHIGX), 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 a bond is not going to be determined just by what happens with the tax code. 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 risks is the impending return of at least slightly tighter monetary policy. The Federal Reserve is set to begin reducing its purchases of bonds, and interest rates are also likely to begin rising, especially if inflation doesn't diminish. Rising rates are a concern because they could push down prices on bonds with longer maturities.

McLaughlin says that with higher rates possible, managing duration is important. Duration is a measure of how sensitive a bond's price is to changes in interest rates and longer duration bonds may be vulnerable to losing value when rates rise. "Duration management is important," she says. "For example, our intermediate muni income fund is benchmarked to the Bloomberg Barclays Intermediate Index. Most of our competitors are much longer in duration than we are and that could help our performance in comparison."

Consider credit risk

Credit risk is the risk that the issuer will default or be unable to make required principal or interest payments and it's always a concern for bond investors. The good news is that munis' generally low risk of default appears to be getting even lower. Over the past year, the federal government has transferred large amounts of money from taxpayers across the country to municipal governments. These transfers and better-than-expected tax revenues 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 recently 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, 0.10% of muni bonds defaulted, according to Moody's Investors Services. 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. Despite the fact that many municipal bonds have high credit ratings, there is a risk of default in any bond investment.

And not all muni bonds have low credit risk. High-yield municipal bonds, which have historically defaulted at an average rate of 7.47%, have been attracting interest and money from investors. Unlike governments, though, the issuers of these bonds mostly haven't benefited from bailouts and many have taken the opportunity created by increased demand for munis to issue bonds for projects that wouldn't otherwise get funded.

"We've seen a lot of really speculative project financing that doesn't benefit from federal aid, like building small, single-site projects in remote areas," says McLaughlin. "Whenever rates are very low, people look for yield and you see big inflows into high-yield funds. That allows more speculative deals that otherwise wouldn't get the time of day to make their way into investment products. A lot of speculative, private project financing deals have gotten done this year."

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. 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 can provide a level of stability for a well-diversified portfolio and 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 municipal bonds through investing in mutual funds and ETFs or by buying individual bonds. Each approach has its pros and cons and research can help you decide which to choose. 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.

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