Unlocking Equity-Like Returns with Municipal Bonds

One of them happens to be municipal bonds.

Ever since the Fed’s rate hikes, munis have provided very strong after-tax yields. And now those yields are almost equity-like in terms of returns. For investors, it’s just another reason to add municipal bonds to their fixed income sleeves.

The last two years have been marked by one thing: the rise in interest rates. We all know what happened. Inflation was running high in the post-pandemic world and the Federal Reserve moved interest rates from zero to the current 5.5%. It’s been several meetings since the Fed raised rates and it doesn’t look like the central bank will cut rates anytime soon based on stubborn inflation.

With that, a variety of bonds are now providing high yields. That includes municipal bonds.

That’s to the Fed, munis are still paying the most they have since 2013. The sector benchmark—the Bloomberg Municipal Bond Index—is currently featuring a yield to worst of almost 4%. This chart from asset manager Lord Abbett shows the continued spike in municipal bond yields.

Source: Lord Abbett

Historically speaking, this is a rare feat. Analysts at Chase show that municipal bond yields have only been this high for a few months in the 15 years since the Great Recession.

Where it gets interesting is how those yields present themselves. That’s because, unlike most other bond types, municipal bonds are generally tax-free. Since they are issued by states and other local governments, Uncle Sam is willing to give investors a break. Munis are generally free from federal taxes and, in many cases, state/local taxes as well.

Because of this, munis are often quoted with after-tax yield, meaning investors would have to earn this yield to match what munis are paying when you factor in taxes.

Right now, the after-tax yield is very juicy. Vanguard breaks it down. Investors in the top federal income tax bracket pay 37% at the federal level plus a 3.8% Medicare surtax. When muni bond yields are at 1%, as they roughly were during the pandemic, the after-tax yield only added on about 0.69 percentage points. However, with munis now yielding around 4%, the after-tax yield jumps by 2.76 percentage points. This provides an after-tax yield of around 6.76%. ¹

Factoring in state taxes and the after-tax yields could be nearly 9%. For example, investors in California have a current after-tax yield of 8.7%, while those in New York get 8.3%.

The kicker? Chase shows that these high after-tax yields are roughly the same as, or in some cases more than, the average annual return of the S&P 500 (6.7%) since 2000. ²

The best part is that even for investors in lower tax brackets, munis still offer a great after-tax yield that comes close to average market returns over the long haul.

Those equity-like returns come with lower volatility too. Because bond investors will get their principal back when a bond matures, they generally don’t feature high bounciness over the long haul. The bond rout of 2022 when the Fed raised rates was actually a real anomaly compared to the norm.

Municipals are particularly low-volatility due to their low default rates. Since 2017, municipal bond defaults have averaged 0.14% annually. That’s slightly higher than the real long-term average, but Puerto Rico’s default bumped up the average. But even then, when it did, defaults were still less than 1% for the year. With rainy day funds still fat and many states already clamping down on budgets, munis aren’t expected to spike this year or next.

With after-tax yields so high, investors have a chance to add equity-like returns to their portfolios without adding real risk. That’s a huge opportunity.

With yields for municipal bonds still riding high and now matching or eclipsing the long-term return of the stock market, investors may want to seriously consider adding them to a portfolio. The opportunity won’t last long. Once the Fed starts cutting interest rates, the bonds should rise in price and reduce the after-tax yield. However, investors who act early will lock in that yield and score some capital gains.

The devil is in the details. Buying individual munis is a tough nut to crack. Wide bid-ask spreads are commonplace in the secondary markets and supplies of new munis are generally gobbled up by big investors when issued.

To that end, ETFs make for a great muni bond allocation tool. Vanguard notes that there are approximately 30,000 local and state governments/agencies that actively come to market to sell muni bonds. In total, there are more than three times the number of actual munis on the market than corporate bonds. Active management can play a real role in producing returns in this sector.

These funds were selected based on their exposure to municipal bonds at a low cost. They are sorted by their YTD total return, which ranges from -0.5% to 0.9%. They have expense ratios between 0.05% to 0.65% and assets under management between $1.2B to $37B. They are currently yielding between 1.9% and 3.7%.

Overall, municipal bonds are currently offering a compelling opportunity to reduce a portfolio’s risk profile while still offering high returns. For investors looking for income or a strong total return otherwise, they should consider adding the bonds to a portfolio.

Thanks to the Federal Reserve’s continued pause on rates, municipal bonds are offering something investors can’t get elsewhere: equity-like returns with low risk. Thanks to their high after-tax yields, munis could now be a strong return element for a portfolio. The opportunity won’t last long. Investors should be ready to pounce today.

¹ Vanguard (May 2024). Capitalizing on opportunities in the municipal bond market.

¹ Chase (January 2024). A rare municipal bond opportunity: Unusually high yields