It’s dangerous to blindly accept “conventional wisdom,” especially when it comes to investments. Take municipal bonds, which are debt securities issued by state and local governments to fund spending on schools, highways or other infrastructure projects., explains Richard Moroney, editor of Dow Theory Forecasts.
Investors like muni bonds because their interest is exempt from federal taxes. Interest payments are usually exempt from state taxes as well, if the bondholder lives in the state that issued the security.
Conventional wisdom suggests that after tax reform lowered individual taxes for many households, the appeal of munis should diminish. After all, lower tax rates reduce the after-tax yield spread between tax-exempt and taxable bonds. So far, conventional wisdom has been wrong.
According to research firm Municipal Market Analytics, more than $15 billion has poured into muni funds in the first eight weeks of the year, the most in at least 13 years. At least three factors are driving demand:
➤ Investors continue to chase performance. Munis outperformed Treasurys and investment-grade corporate debt in 2018 for the first time in three years.
➤ The Fed’s pivot on interest rates boosts the appeal of fixed-income investments. With the Federal Reserve Board now seemingly taking a more dovish approach to rate hikes, investors have become more comfortable with interest-rate-sensitive investments, such as munis.
➤ Many households feel “SALT” in their wounds. While the new law lowered tax rates for many Americans, some changes, especially the cap on the deductibility of state and local taxes (SALT) at $10,000, have hit investors hard in certain high-tax states. Thus, munis become an attractive tax shelter of sorts.
The increased demand for munis has pushed down yields, with the yield on the Bloomberg Barclays Municipal Bond index recently touching its lowest level in a year below 2.6%. Still, for investors in the top tax bracket (37%), that yield equates to a taxable yield of around 4%.
To be sure, demand for munis issued by high-tax states (think California, New York, Connecticut, and Illinois, to name four) may be pushing prices up and yields down to levels that don’t adequately compensate for risk.
While investors have traditionally viewed muni debt as relatively safe given historically low default rates and the government’s ability to levy taxes, unfunded pension liabilities ramp up the risk level of certain muni bonds.
Partly as a result of this increased risk, muni bond investors should diversify in the space. To that end, investors interested in munis should consider low-cost mutual funds and exchange-traded funds.
Vanguard’s roster of open-end, tax-exempt funds includes the Vanguard Limited- Term Tax Exempt (VMLTX) and Vanguard Intermediate-Term Tax Exempt (VWITX).
Vanguard Limited-Term Tax Exempt has a current yield of around 1.8% and an average maturity (remaining lifespan) of about three years.
The Vanguard Intermediate-Term Tax Exempt has an average effective maturity of 5.5 years and a current yield of around 2.2%. Both funds earn an A rating for average credit quality and charge annual expenses of just 0.17%.
On the ETF side, the Vanguard Tax-Exempt Bond (VTEB) has an average maturity of nearly six years and a current yield of 2.3%. Average credit quality is AA, with expenses at a low 0.08%.
