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Muni bonds with a twist

Key takeaways

  • Taxable bonds make up a small segment of the $3.8 trillion municipal bond market but new issuance is increasing rapidly.
  • Taxable muni bonds may compare favorably with other taxable bonds in terms of price, default risk, and sensitivity to changes in interest rates.
  • Investors may use taxable municipal bonds to help diversify their portfolios, especially in 401(k)s and IRAs.
  • Though interest payments on taxable muni bonds are not exempt from federal income tax, they may be exempt from state and local taxes, potentially raising their after-tax yields compared with investment-grade corporate bonds.

Municipal bonds' reliable income payments, low likelihood of default and, perhaps most of all, unique exemption from federal and some state income taxes have long earned them a special place in the hearts and portfolios of many investors. But would muni bonds without all those virtues still be attractive? If you're looking for relatively low risk, diversification, and potentially attractive yield in your portfolio, the answer may be "yes."

An under-the-radar asset class

While even knowledgeable investors may be surprised to discover taxable munis, municipalities have been issuing taxable bonds since 1986 when federal tax reform restricted the activities that tax‐exempt bonds could be used to fund. For the next 30 years, taxable munis made up between 3% and 7% of the total bonds issued by municipalities each year.1 More recently, though, further tax reforms have caused the number of new bonds coming into the market to surge to more than 3 times that level. That increase in the pool of bonds from which to choose has made it easier for investors who want to add these bonds to their portfolios.

The 2017 Tax Cuts and Jobs Act prohibited cities, states, and other municipalities from issuing tax-free bonds for the purpose of restructuring their existing debts. These "advance refunding" bonds had been a popular way for indebted issuers to lower their borrowing costs and postpone spending cuts, much in the way that a homeowner might refinance a mortgage to lower their interest payments rather than downsizing to a more affordable house. Many governments have similarly opted to issue taxable bonds to fund the sorts of activities that they once issued tax-free bonds for. Since the ban on tax-free advance refundings took effect in 2018, taxable muni issuance jumped to $70 billion in 2019 (17% of all new munis issued) and to $120 billion in 2020.2

Supply and demand

Within the taxable muniverse, the value of bonds whose interest payments are taxable by the federal government as ordinary income is approximately $539 billion, up from $468 billion in 2019. Another $169 billion worth of bonds pay interest that is subject to the alternative minimum tax. Roughly 40% of the taxable munis in the market have been issued by California, New York, and Texas.3 State general obligation bonds are the largest sector in the taxable municipal index at 18%, followed by transportation at 15%, education at 12%, and tax‐backed at 12%. Since 2019, transportation, education, and tax‐backed sectors have all grown as a share of the index.

Share of taxable muni bonds that fund various activities

ICE B of A Broad US Taxable Municipal Securities Index

Source: ICE Data Indices, LLC, FCM; As of August 10, 2020

Are taxable munis good for the bondholders?

While taxable munis provide governments with obvious short-term help for managing their fiscal challenges, the benefits they offer to would-be bondholders may be less immediately clear. Without the tax exemption, after all, what's the point of munis?

While they lack the attractive tax benefits of tax-free bonds, taxable munis can be an attractive alternative to corporate bonds. From 2010 to 2019, taxable munis generated an annualized total return of 5.51%, compared with 5.14% for corporates, and 3.97% for tax-exempt munis. Meanwhile, they also showed less sensitivity to rising interest rates, with an average effective duration of 5.7 years compared with 6.4 years for corporate bonds over the same time.4 Duration is a measure of how sensitive bonds are to changes in interest rates, and lower duration means that a bond's price may fall less than those of other bonds if rates rise.

Past performance, of course, is no guarantee of future return, but taxable munis offer an opportunity to diversify away some of the credit risk in portfolios that hold corporate bonds. While many corporate bonds continue to face potential downgrades amid an uneven economic recovery, municipal credit quality remains relatively high. In fact, many forecasts of budget shortfalls and lower tax collections are turning out to not be as severe as had been anticipated.

Other taxable munis in the market

In the past, the federal government supported taxable bond issues by state or local governments to promote policy goals such as infrastructure improvement and energy conservation. Many of these bonds are still in the market, including the Build America Bonds, Recovery Zone Economic Development Bonds, and Qualified School Construction Bonds, authorized by a federal program after the 2008 financial crisis. Issuers receive a 35% federal rebate on interest costs for these bonds which are not backed by the federal government.

Another federal program promoted issuance of what are known as qualified tax credit bonds. Holders of these bonds receive federal income tax credits rather than interest payments. Tax credit bond programs include Qualified Zone Academy Bonds, Clean Renewable Energy Bonds, Qualified Energy Conservation Bonds, and Qualified Renewable Energy Bonds. The 2017 tax reform ended issuance of new tax credit bonds but a significant number remain in the market.

Taxable munis are backed by all the same sources of tax revenue that back tax‐exempt bonds from the same issuers. That means they offer investors the same high credit quality that has traditionally been part of the appeal of municipal bonds. In 2020, 70% of the bonds in the broad taxable municipal index had credit ratings in the top 2 categories, up from 68% in 2019. That compares to only 9% of investment-grade corporate bonds in those categories, down from 11% in 2019.5

Another distinction between taxable munis and corporate bonds lies in their potential tax implications. Though interest payments from taxable munis are subject to federal income tax, they can be exempt from state and local income taxes if you live in the same state as the issuer. This means that depending on where you live, the after‐tax yield on a taxable muni bond may well be higher than the after‐tax yield on a corporate bond with similar credit quality and duration, which is taxed at the federal, state, and local level.

How to use them

While tax-free muni bonds may be less than ideally suited for retirement savings in tax-deferred accounts, taxable munis may make sense as portfolio diversifiers in accounts such as IRAs and 401(k)s where interest earned is tax-deferred.

Income-seeking investors looking to build ladders of municipal bonds in which bonds are held until maturity should know that unlike tax-free munis, taxable munis often include what are known as "make‐whole call" or "emergency redemption" provisions. Both of these give the issuer the right to redeem the bond before it matures and pay the bondholder cash in a lump sum.

While taxable municipal securities can certainly be advantageous under certain circumstances, an investor should consider the overall impact of, among other things, federal income tax on interest. Investors should consult their tax advisor for guidance on the specifics of tax liabilities related to municipal securities.

Find out more at our bond research page.

Finding taxable muni bonds

Investors interested in taxable municipal bonds have a variety of ways to gain exposure to them.

If you believe you have the time, skill, and will to build and manage it yourself, buying individual bonds may be appealing. Doing it yourself lets you choose specific bonds and hold them until they mature, if you choose. That can help you avoid much of the risk that changes in interest rates and prices might pose to investors in mutual funds. However, you still would face the risks that an issuer might default or call the bonds prior to maturity. So this approach requires you to closely monitor the finances of each issuer whose bonds you're considering. You also need enough money to buy a variety of bonds to diversify away at least some risk. Learn more 

Buying shares of a bond mutual fund or ETF is an easy way to add a taxable muni bond position. Bond funds hold a wide range of individual bonds, which makes them an easy way to diversify your holdings even with a small investment. You can run screens using the Mutual Fund and ETF Screeners on Fidelity.com. Below are the results of some illustrative fund screens (these are not recommendations of Fidelity).

MainStay MacKay U.S. Infrastructure Bond Fund Class A (MGVAX)

Invesco Taxable Municipal Bond (BAB)

BlackRock Taxable Municipal Bond Trust (BBN)

Guggenheim Taxable Municipal Bond & Investment Grade Debt Trust (GBAB)

Nuveen Taxable Municipal Income Fund (NBB)

The Fidelity screeners are research tools provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with preselected criteria (including expert ones) are solely for the convenience of the user. Expert screeners are provided by independent companies not affiliated with Fidelity. Information supplied or obtained from these screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsement by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange-traded products, or closed-end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from its use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation, and other individual factors, and reevaluate them on a periodic basis.

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1,2,3,4,5 Overview of the Taxable Municipal Market, Fidelity Capital Markets white paper, summer 2020 Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

This information is intended to be educational and is not tailored to the investment needs of any specific investor.

Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

ICE BofA Broad US Taxable Municipal Securities Index: ICE BofA Broad US Taxable Municipal Securities Index tracks the performance of U.S. dollar denominated debt publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. domestic market. Qualifying securities must be subject to U.S. federal taxes and must have at least 18 months to maturity at point of issuance, at least one year remaining term to final maturity to enter the index and one month remaining term to final maturity to remain in the index, a fixed coupon schedule (including zero coupon bonds) and an investment grade rating (based on an average of Moody’s, S&P and Fitch). The call date on which a pre‐refunded bond will be redeemed is used for purposes of determining qualification with respect to final maturity requirements. Minimum size requirements vary based on the initial term to final maturity at time of issuance. Securities with an initial term to final maturity greater than or equal to one year and less than five years must have a current amount outstanding of at least $10 million. Securities with an initial term to final maturity greater than or equal to five years and less than ten years must have a current amount outstanding of at least $15 million. Securities with an initial term to final maturity of ten years or more must have a current amount outstanding of at least $25 million. “Direct pay” Build America Bonds (i.e., a direct federal subsidy is paid to the issuer) qualify for inclusion in the index, but “tax‐credit” Build America Bonds (i.e., where the investor receives a tax credit on the interest payments) do not. Local bonds issued by U.S. territories within their jurisdictions that are tax exempt within the U.S. territory but not elsewhere are excluded from the Index. All 144a securities, both with and without registration rights, and securities in legal default are excluded from the Index. Index constituents are market capitalization weighted. Accrued interest is calculated assuming next‐day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the index. Information concerning constituent bond prices, timing and conventions is provided in the ICE BofA Bond Index Guide, which can be accessed on our public website (www.mlindex.ml.com), or by sending a request to iceindices@theice.com. The index is rebalanced on the last calendar day of the month, based on information available up to and including the third business day before the last business day of the month. New issues must settle on or before the calendar month end rebalancing date in order to qualify for the coming month. No changes are made to constituent holdings other than on month end rebalancing dates. Inception date: December 31, 2009.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

High-yield/non-investment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.

The municipal market can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Although state-specific municipal funds seek to provide interest dividends exempt from both federal and state income taxes and some of these funds may seek to generate income that is also exempt from federal alternative minimum tax, outcomes cannot be guaranteed, and the funds may generate some income subject to these taxes. Residency in the state is usually required for the state income tax exemption. Generally, municipal securities are not appropriate for tax advantaged accounts such as IRAs and 401(k)s.

Past performance is no guarantee of future results.

Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.

Indexes are unmanaged. It is not possible to invest directly in an index.

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