Muni bonds pack a one-two punch

Now that the baby boomer generation is transitioning into retirement, the need for income and the desire to…

Now that the baby boomer generation is transitioning into retirement, the need for income and the desire to avoid taxes should increase the demand for tax-free municipal bonds.

The recent volatility in the muni bond market has created an opportunity to restore income to retirement-oriented investment portfolios. Cheaper muni bond yields, in combination with higher tax rates, offer investors who are retired a chance to earn and, more critically, keep a high level of after-tax income.

However, just clipping coupons won't be enough to protect these investors from future inflation. To preserve the purchasing power of their investment income, retirees will need to maximize total return through active management.

It is important that retirees and pre-retirees are aware that muni bonds do encounter challenges periodically. This ranges from concerns over defaults based on the large number of issuers, to worries that Congress may modify tax rates or possibly end the tax-exempt status of muni bonds.

That being said, muni bonds may still be worthwhile as part of a well-diversified portfolio.

This past summer, the muni market was gripped by a liquidity squeeze that drove yields significantly higher. The yield on a 30-year AAA-rated muni bond is now about 115% of the yield on a comparable Treasury security, meaning that the tax-exempt bond has a higher nominal yield.

Even more compelling is the fact that long-dated A-rated tax-exempt bonds are trading at higher yields than similarly structured A-rated corporate bonds for only the second time since 2000, according to data from JPMorgan Chase & Co.

Ironically, the condition that created so much pain for investors during the summer should now be viewed as an opportunity.

TAX ENVIRONMENT

The second, and more important, reason to consider muni bonds is the tax environment. The combination of the highest marginal tax rate (39.6%) and the new Medicare surcharge (3.8%) means that all investment income, except for muni bond income, is now subject to a combined top federal tax rate of 43.4%.

Therefore, a single-A-rated muni bond yielding 5% translates into a taxable-equivalent yield of over 8.8%. That is a higher level of return than the average return on the S&P 500 for the past 20 years.

Although not all investors are subject to the highest tax rates, it would be imprudent to ignore the potential impact that higher taxes likely will have on muni valuations.

When this is considered in combination with rising demand expected from a quickly growing population of retirees, the expectation of strong price support for muni bonds is reasonable.

Given current muni-to-Treasury yield ratios, muni bonds have a performance “cushion” built in. This results from an expectation that yield ratios will normalize over time, which is reasonable.

So when pundits talk about “the great rotation” away from fixed income, they are ignoring the value embedded in the muni market. Another concern is interest rate risk.

Eventually, inflation will increase from these low levels. As this occurs, the purchasing power of fixed-income investments will decline.

This suggests that a buy-and-hold, clip-the-coupon approach to investing in muni bonds will result in less-than-optimal results.

Instead, investors can offset the drag of inflation by employing an actively managed total-rate-of-return approach that is oriented toward making credit-based relative-value decisions. The recent sell-off in the market, for example, caused credit spreads on lower-rated and high-yield muni bonds to widen.

However, muni finance fundamentals, in general, have been improving, and it looks like the spread widening is largely technical. Investors should be rewarded for being overweight these credit segments.

As soon as those spreads tighten again, we anticipate selling those securities and moving the proceeds into other, cheaper segments of the market, thus coming full circle on a relative-value-driven strategy.

In summary, the recent backup in muni yields has created an opportunity for retirees and near-retirees to restore higher levels of income to their portfolios. In addition, it is expected that higher tax rates — now a reality — further enhance the attractiveness of muni bonds relative to the rest of the fixed-income market.

Robert DiMella is a senior managing director and co-head of MacKay Municipal Managers, a unit of MacKay Shields. He is also the portfolio manager of the MainStay Tax Free Bond Fund.