If municipal bond investors aren’t seeing returns of more than 6.00%, they’re missing the obvious.
The key, of course, is focusing on tax-equivalency.
As longtime investors know, generating a steady stream of tax-exempt income while sleeping peacefully at night is the hallmark of municipal bonds.
But while munis are designed to be drama-free, there’s still a thrill when investors figure out just how much they’ll reap in real value.
Tax-equivalent muni yields change the equation
Think about it: Today, yields on long-term, AA-rated munis average about 3.50%. Seems a long way from 6.00% – until you consider the tax implications.
For example, a recent Barron’s article, “Where to Find Safe 5% Yields,” looked at a married California couple with an annual income of $250,000.
If you figure they pay 35% in federal taxes, 3.8% for Medicare and 9.3% for state taxes, their total tax rate is 48.1%.
To determine the tax-equivalent yield, take the stated yield (3.00% in the example above) and divide it by 1 minus the tax rate (48.1%).
This modest 3.00% municipal bond yield is now supercharged into an after-tax yield of nearly 5.80%. Peace of mind as well as a healthy return.
Actually, a muni investor can receive a yield to-maturity of over 3.50% on long-term, AA-rated bonds, which translates into a whopping 6.74% for those same California investors.
For residents of Florida or Texas, which have no state income tax, that 3.50% return would be comparable to a 5.71% return on a taxable fixed-income investment (Corporate or Treasury bonds).
As one investment manager remarked to Barron’s, “It’s not just a marginal benefit for a high-income investor to invest in munis. It’s a very large benefit.”
Muni investors’ thirst for quality, yields never quenched
Individual investors’ thirst for quality munis continues to be strong.
As we’ve pointed out (“Abroad Appeal For Muni Bonds”), last year’s tax overhaul lowered federal income taxes, but only slightly, and lawmakers capped the deduction of state and local taxes.
As for the Fed’s recent moves nudging up short-term interest rates?
Remember, for municipal bond investors, it’s about long-term interest rates. The equation doesn’t change.
In our experience, investors unhappy over yields are usually those who are less experienced in the market and fail to fully consider the after-tax boost.
Instead, they keep their investable dollars on the sidelines, waiting for yields to rise.
They earn next to nothing in money-market funds while foregoing a dependable flow of tax-free income.
For fixed-income investors, higher yields are hiding in plain sight.