Munis Deliver for Fixed Income InvestorsDecember 23, 2019
- Munis can provide a potential income stream that is tax-free at the federal level.
- The two main types of munis, general obligation bonds and revenue bonds, carry different risks.
- Munis traditionally have a low default rate and offer diversification benefits to investor portfolios.
Municipal bonds (or munis) issued by state and local governments provide investors with tax-free income potential and the benefits of diversification—important aspects of a long-term investor’s portfolio. Investor demand for munis has remained robust in recent years despite news about troubled issuers. Tightening monetary policy and rising interest rates can also create periods of volatility. However, it is rare for a municipality to default or miss an interest or principal payment to bondholders, which is one of the biggest reasons why they remain attractive to investors.
What’s more, municipal bonds’ tax and diversification benefits can provide investors with longer-term advantages. “The tax advantages and regular income mean that investors in every tax bracket should consider whether munis might be a good fit for the fixed income portion of their portfolios,” says Hugh McGuirk, head of municipal bond investing at T. Rowe Price.
What are munis?
Municipal bonds are tax-exempt debt obligations issued by cities, counties, states, and other government entities. They are used to fund infrastructure projects, essential services, and other endeavors that serve the public interest. There are two main types of munis:
- General obligation bonds are backed by the issuer’s ability to raise money through taxes and may support efforts such as school and road construction.
- Revenue bonds are issued by a government-related entity to fund a particular project, such as an airport or a hospital wing. Revenues generated by those entities are used to pay the interest and principal to muni investors.
What are the benefits to investors?
Munis offer investors a potential income stream exempt from federal income taxes. Income generated by munis issued in an investor’s home state is also typically exempt from state income taxes. The value of these benefits depends on your tax situation and is more significant for investors in higher tax brackets or for those who live in high-tax jurisdictions. Since 2018, following passage of the 2017 tax law, the federal tax deduction for state and local taxes has been limited, which may make local munis even more attractive for investors.
Keep in mind that these tax advantages apply when munis are held in taxable accounts. Muni yields are typically lower than pretax yields on taxable bonds with comparable credit ratings and maturities. (See “A Primer on Tax-Equivalent Yield.”) As a result, they may not make sense in Traditional and Roth IRAs. It is important to note that some interest income may be subject to state and local taxes as well as the federal alternative minimum tax. In addition, any gain on the sale of a muni bond in a taxable account is still subject to capital gains taxes.
While investors can choose from a wide array of muni issues, which vary in purpose, maturity, and yield, you should consider investing in municipal bond mutual funds—also known as tax-free bond funds—to achieve greater diversity in your holdings. Municipal bond mutual funds also enable investors to benefit from the expertise of professional managers and analysts who perform essential credit research in an effort to navigate market changes effectively. Of course, diversification cannot assure a profit or protect against loss in a declining market. All mutual fund investments are subject to market risk, including the possible loss of principal.
As an example of the research that goes into constructing an actively managed tax-free bond fund, a special team of T. Rowe Price analysts identified Puerto Rico’s municipal bond risks a year before the commonwealth’s financial problems were widely publicized and long before the bonds were downgraded. While Puerto Rico’s fiscal distress presented unique challenges, T. Rowe Price muni analysts regularly visit bond issuers, such as hospitals, meeting with management and evaluating the condition of a facility’s physical plant before recommending that a bond should be purchased.
Investors are often willing to accept a lower yield compared with the pretax yield on a similar taxable bond. To see the pretax yield you would have to earn on a taxable bond to equal a 2% tax-free yield on a municipal bond, select your federal tax bracket below.
*Does not include the 3.8% net investment income tax (NIIT); see irs.gov for more information. Chart also does not reflect any potential state or local tax benefit. Note that factoring in the NIIT and state and local income taxes, where applicable, would result in higher taxable-equivalent yields.
What are the risks?
Like other investments, municipal bonds carry certain risks. For instance, although rates have remained below long-term averages in recent years, rising interest rates will cause bond prices to drop. Muni investors should also be mindful of credit risk, which represents the potential that a bond issuer will fail to make timely interest and principal payments to its bondholders, resulting in a default.
While the fiscal problems that challenge some large muni bond issuers garnered headlines, municipal bankruptcies historically have been relatively rare. When defaults have occurred, they have represented a minuscule portion of a large market. One study found that the 10-year cumulative default rate for all rated municipal credits was 0.17% over the 1970–2017 period.* In contrast, the cumulative default rate for all rated corporate issuers was 10.24%. Additionally, the muni market typically recovers quickly following an event that pushes investors away from munis. (See “A History of Sell Offs and Recoveries Among Munis.”)
Although the muni market is overwhelmingly high quality, many states and municipalities are struggling with underfunded pensions and other post-employment benefit (OPEB) obligations. In this environment, T. Rowe Price portfolio managers generally favor bonds backed by a dedicated revenue stream over general obligation bonds, as revenue bonds have less exposure to the pension funding concerns facing state and local governments.
Revenue bonds also typically offer an incremental yield advantage over state and local general obligation debt. However, investors must assess whether individual projects will be financially viable over the long term and fully understand how deals are structured, which underscores the importance of fundamental credit research. Regardless of market conditions, municipal bonds continue to play an important role in a well-designed fixed income portfolio.
Market forces can prompt investors to sell their municipal bond holdings, but the muni market historically has bounced back relatively quickly after such events.
Source: Bloomberg Barclays Municipal Bond Return Drawdowns. A drawdown represents the decline in price of a particular investment or asset class expressed in percentage terms.
*Moody’s Investors Service, U.S. Municipal Bond Defaults and Recoveries, 1970–2017.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of October 2019 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.
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