Fixed Income: Is the Playing Field Leveling Off?

03.17.2021 - Kyle Baker, Fixed Income Portfolio Manager

Of all the questions that fixed income investors face when considering their investment options, “How much income am I left with after taxes?” usually sits near the top of the list.  

For taxable investors in the highest tax bracket, the answer has traditionally started with tax-exempt municipals. Historically, this straight-forward take on fixed income allocations tended to provide the best outcome. However, drastically declining yields in bond markets over the last couple years, particularly in tax-exempt municipals, have dominated the landscape. At yearend 2018, yields on the highest-rated, five-year municipals yielded 1.96%; today, it’s about 0.41%.[1] For investors looking for meaningful after-tax income, the marketplace has become increasingly challenged.

Tax-Exempt Demand Has Been Strong …

The current environment has resulted from several dynamics that have unfolded over the last few years. First, demand for tax-exempt income has been truly remarkable. Fund flows into municipals have been impressive, totaling $157 billion over the last two years.[2] Helping drive this influx of cash has been the recent US elections which saw Democrats gain control of the White House and Congress. With this shift in Washington, the likelihood of higher taxes on the wealthy seems to have increased, adding to the demand for tax-exempt income.

… While Its Supply Has Dwindled

Meanwhile, the market has witnessed a decrease in supply due partly to conservative fiscal policies and COVID-19-related uncertainty at state and local government levels. Further, some new issues that would have historically been tax-exempt have crossed over into taxable issuance. This has been largely driven by the Tax Cuts and Jobs Act, as advanced refundings were no longer able to refinance debt with tax-exempt bonds. But with rates declining, state and local governments can still issue taxable municipals and save on some interest expenses. In fact, taxable municipal issuance rose 141% in 2019 and 101% in 2020.[3]

Looking Beyond Municipals

With municipal markets providing diminishing income opportunities, taxable markets may offer some relief. Lately, US Treasury yields have moved upward, particularly in longer-maturity bonds. Prospects of an economic reopening, more fiscal stimulus, plus pent-up demand and massive savings[4], have created expectations for a strong rebound in growth and inflation later this year. Short-maturity US Treasuries, however, continue to be anchored by the Federal Reserve’s accommodative stance and their ongoing commitment to support financial markets. Taken together, this has led to the yield curve steepening.

So, with five-year tax-exempt munis yielding roughly half of their US Treasury counterpart, what’s a taxable investor to do?

Are Taxable Bonds Becoming More Attractive?

Figure 1 shows yields for high-quality taxable investments alongside comparable tax-exempt municipals over the last two years. Clearly, spreads have narrowed since their March 2020 highs.

Figure 1: The Taxable-Tax Exempt Gap Has Been Narrowing

Tax-Exempt Municipal vs. After-Tax US Treasury Yields (%) and Corporate Yields (%) over Trailing Two Years

Source: Bloomberg, as of 3/16/2021.

For an investor in the top tax bracket, five-year US Treasuries offered 0.53% on an after-tax basis (see Figure 2). Indeed, US Treasuries outyielded these same bonds on an after-tax basis for most of the last three months (see Figure 1), providing taxable investors with a potential alternative to traditional tax-exempt municipals.

Figure 2: The Playing Field Has Been Leveling Off

Fixed Income Yields (%) as of 3/16/2021

Source: Bloomberg. After-tax yield calculated by multiplying yield by the top tax bracket (37%). For example, US Treasury yield (0.84%) is multiplied by 0.37% equals 0.31% which is subtracted from the US Treasury yield, providing an after-tax return of 0.53%.

Expanding this exercise to other high-quality securities aside from just AAA-rated issuers, we find echoes of the yield compression seen in the safest taxable and tax-exempt securities. Figure 2 shows that intermediate maturity tax-exempt municipals yielded around 0.90% recently. If one assumed some credit risk in the taxable market—similar-maturity US investment grade corporates, for instance—yields would be in the range of 1.31%, or 0.82% after-tax. Clearly, there does not appear to be an overwhelming advantage to swapping into the taxable market based on this comparison, but there is reason to be flexible given the minimal size of the gap and low absolute yields.

The takeaway in both instances is that the playing field may be leveling off and we need to remain aware of these after-tax relationships to take advantage of potential opportunities.

What do we think?

At Fiduciary Trust, we have always built portfolios with an eye on the best after-tax, risk-adjusted outcomes for clients. Tax-exempt municipals traditionally lag moves in taxable bonds and the sector’s recent outperformance relative to the broader market has been no exception. However, such performance occasionally creates gaps between taxable and tax-exempt yields. In the search for higher after-tax yield, we think taxable investors should consider investments outside of the traditional municipal universe, where opportunities to add incremental yield can be appealing, even on an after-tax basis.

[1] Source: Bloomberg as of 3/16/2021.

[2] Source: Bloomberg as of 12/31/2020. Refers to last two calendar years.

[3] Source: Bloomberg. Changes are shown relative to 2018.

[4] Source: Federal Reserve Bank of St Louis, as of 1/29/2021. The personal savings rate was 13.7% in December 2020 compared to the five-year trailing average 9.13%.

This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.


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