Fixed-income investing has gained attention in recent times due to the rise in yields, reaching levels not seen since the Great Recession of 2007-2008. U.S. Treasuries are now trading between 4% and 5%, leading to increased demand for fixed-income securities such as municipal bonds and corporate bonds. In 2023, fixed income was the only category to post positive fund inflows, adding $395 billion to bond funds. Specifically, $8.35 billion flowed into municipal bond mutual funds and ETFs in the first 10 weeks of this year, the largest flow since January 2022.
This increased demand has benefited the municipal bond market, with the total return on the Bloomberg Municipal Bond Index outperforming the Bloomberg Treasury and Corporate Bond indexes year-to-date. However, some sectors within the municipal bond market may be considered overbought for some investors, caution is advised. One major advantage of owning municipal bonds is the tax-free income they provide, resulting in lower yields compared to taxable bonds.
For investors in the highest marginal tax bracket, taxable equivalent yield calculations offer insights into choosing between taxable and tax-exempt bonds. With the recent decline in municipal bond yields relative to Treasuries, Treasuries may be a better alternative for high tax-paying investors. The AAA muni-to-Treasury yield ratio, currently below the break-even ratio of 59.2%, indicates municipal bonds may be overvalued, favoring Treasuries for high tax bracket investors.
In addition to Treasuries, investors in the highest tax brackets should also consider corporate bonds as some offer higher after-tax yields compared to municipal bonds. Corporate bond income is taxed at federal, state, and potentially local levels, and careful analysis including risk metrics and credit reviews is necessary when comparing municipal and corporate bonds. The after-tax yield on the Bloomberg Intermediate Corporate Bond Index is currently higher than that on the comparable municipal bond index, presenting opportunities in taxable corporate bonds.
Investors should review any investment on an after-tax basis specific to their individual circumstances. While the traditional approach for high-net-worth investors of exclusively buying municipal bonds may need to be questioned in light of current market conditions, careful analysis can reveal attractive investments. With the renewed interest in fixed income investments, it is essential for investors to consider after-tax implications to maximize opportunities in the market.
