A light finally shines on municipal bonds
By Tim Gray
The big perk of municipal bonds is that they are exempt from federal taxes.
But that benefit comes at a cost: Their yields are usually lower than those of comparable taxable bonds.
In May, the cost briefly disappeared, as the average yields on municipal bonds pulled even with those of U.S. Treasury securities. Investors were, in effect, enjoying municipal bonds’ tax benefits free.
Unfortunately, another cost loomed. Rising yields mean falling prices, as bond yields and prices move in opposite directions. So far this year, people who own municipal bond mutual funds and exchange-traded funds have seen the value of their investments sink.
As of June 30, the S&P Municipal Bond Index had lost about 8.4% this year, with the first quarter being especially doleful.
“Q1 2022 was the worst calendar quarter return for the municipal market in 40 years,” said Elizah McLaughlin, a municipal bond portfolio manager for Fidelity Investments.
A variety of factors contributed to those returns, but the biggest has been the Federal Reserve’s push to raise interest rates to fight inflation, McLaughlin said. The central bank has increased the short-term interest rate it controls three times this year, including an unusually large increase of three-quarters of a percentage point in June.
Fidelity’s Intermediate Municipal Income Fund lost 6.8% in the first half of the year and yields 2.6%.
Investors have responded to municipal bond funds’ woes by fleeing. About $75 billion was pulled out of funds tracked by Morningstar through the end of June, compared with inflows of about $62 billion for the same period in 2021.
But investors may now have reasons for optimism. For the first time in years, municipal bond yields are rising, and many state and local governments — the main issuers of these bonds — are financially flush and carrying strong credit ratings.
“Everyone expected state and local governments to suffer more from COVID than they did,” said Amanda Beck, an accounting professor at Georgia State University in Atlanta. “But they got a lot of federal relief money, and that made up for downfalls in revenue. Plus, property values didn’t fall, so tax revenues didn’t drop as much as was expected.”
The higher yields mean that municipal bond funds and ETFs are providing better income than they have in quite a while.
“When you’re delivering 2% yields, it’s not fun for anybody, and the market was like that for a long time,” said Jim Murphy, head of the municipal bond team and a portfolio manager at T. Rowe Price. “I haven’t seen great value in the market in a long time, but I think the market now, with rates higher, is healthy.”
As of the end of June, T. Rowe Price’s oldest municipal bond fund, its Tax-Free Income Fund, was paying a yield of 3%, up from 2.4% at the end of December. A fund Murphy manages, a high-yield municipal offering that invests “a substantial portion of assets” in junk bonds, was paying 3.4%.
Vanguard called the surge this spring in municipal yields a “renaissance of tax-exempt income.”
Paul Malloy, head of municipal investments at Vanguard, said rising yields should benefit patient long-term investors.
“One of the things we see frequently in municipal markets is a herding effect and people chasing returns on the upside and then, on the downside, saying, ‘Oh, no, I better get out.’ That kind of market timing is something we constantly warn municipal investors against.”
Vanguard’s research has shown that people who jump in and out of markets often buy high and sell low, missing out on the returns they would have by staying invested.
Vanguard’s Tax-Exempt Bond Index Fund lost 8.6% in the first half of this year. The fund, which is also available as an ETF, yields 2.9%.
Municipal bonds are unusual in that they are directly tax-subsidized: The income they produce is exempt from federal, and in some cases state and local, taxes. The higher your tax bracket, the greater the benefit.
Online financial calculators can help with comparing the yields on funds that hold taxable bonds versus municipal bonds.
As an example, imagine someone in the 32% federal tax bracket who is considering Vanguard’s Tax-Exempt Bond ETF. The fund’s tax-equivalent yield for that person would be 4.3%, meaning that a taxable bond fund would have to deliver a 4.3% yield to equal the ETF after taxes have been accounted for. (Any applicable state and local breaks would increase the tax-equivalent yield.)
The tax breaks are one reason financial advisers like Peggy McGillin of Journey Wealth Partners in Concord, Massachusetts, recommend holding municipal bond funds in the taxable portion of a portfolio. Keeping them in a tax-shielded retirement account wastes their tax benefits and locks in their lower stated yields. McGillin said her recommendations on allocation to municipal bonds vary based on the client’s age, income and wealth.
Costs always matter in investing, and low costs are one reason Sandi Bragar, chief client officer at Aspiriant Wealth Management, said she had recently been advising clients to put their municipal bond allocation in Vanguard’s Intermediate-Term Tax-Exempt Fund, which has an expense ratio of 0.17%. (The average municipal bond fund tracked by Morningstar has an expense ratio of 0.76%.)
When assessing an actively managed municipal bond fund, an investor should consider its team of managers and analysts — how many they number and their experience — as well as how the fund’s returns and income have held up in a variety of market conditions, she said.
No one, of course, knows what will happen to the municipal bond market or any market in the months ahead.
But Murphy of T. Rowe Price said states and municipalities have taken the financial steps needed for their bonds to remain prudent bets for investors.
“California is carrying a surplus,” he said. “New Jersey and Illinois, which were poster children for poor fiscal management, have improved. And a lot of states are closing the gap on their underfunded pension problems. That’s still an issue, but it’s probably been put off another decade.”