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What municipal bonds offer investors in today’s markets

Possible future tax hikes and improving credit quality could make these tax-exempt investments an attractive option to consider, says our Chief Investment Office

 

July 23, 2021

 

MUNICIPAL BONDS ARE ENJOYING A MOMENT in the spotlight. Issued by state or local governments to finance construction projects or other needs, municipals, or “munis,” are often seen as relatively safe but sedate investments best known for steady, generally tax-exempt returns. Yet with possible tax rate increases on the horizon and credit quality on an uptrend, “municipal bonds are hitting on all cylinders,” says David Litvack, tax-exempt strategist in the Chief Investment Office (CIO) for Merrill and Bank of America Private Bank.

 

“For bond investors, especially high earners hoping to reduce their tax exposure, now could be a time to consider munis over U.S. Treasurys or corporate bonds,” says Litvack, author of a new “Fixed Income Strategy” report from the CIO. Here, he answers key questions about the advantages and risks of municipal bonds, why they might (or might not) fit your portfolio and what to discuss with your financial advisor.

David Litvack headshot
“For bond investors, especially high earners hoping to reduce their tax exposure, now could be a time to consider munis over U.S. Treasurys or corporate bonds.”

—David Litvack, tax-exempt strategist, Chief Investment Office, Merrill and Bank of America Private Bank

 

Q: Why are municipal bonds performing so well?

A: Demand has risen among investors concerned about possible tax increases, while the supply of new municipal bonds has been relatively limited. Moreover, their credit quality has improved after fears that last year’s pandemic-driven recession could lead many cash-strapped governments to default proved largely unfounded. In fact, total state and local tax revenues for 2020 rose almost 2% from 2019, according to the U.S. Census Bureau, and federal stimulus is promising hundreds of billions of dollars of additional support to governments, transit agencies, airports, higher education and hospitals.

 

All told, municipal bonds have performed comparatively well so far in a year when bonds have generally struggled. While year-to-date Treasury and corporate bond returns were down more than 3% each, the overall municipal bond index was up 0.68%.1

 

Q: What are their tax advantages?

A: While most bond interest is taxed as ordinary income, interest on municipal bonds is typically free from federal income taxes, as well as state and local taxes (generally as long as the bonds are issued in the state where the taxpayer resides). Though their nominal yield is usually lower than for taxable bonds, they may provide a higher after-tax return. Say you’re a taxpayer in the highest (37%) federal bracket and subject to the 3.8% Medicare surtax and 8% state and local taxes. At a combined 48.8%, you would need a corporate bond yielding at least 3.91% in order to earn more, after taxes, than from a tax-exempt municipal bond yielding just 2%.

 

Another important benefit is low credit risk. Despite some high-profile defaults, from 1970 to 2019 the average annual default rate on an investment grade municipal bond has only been about 0.01%, according to Moody’s.

 

Q: What role can they play in my portfolio?

A: While economic recovery and growth favor portfolios weighted towards stocks, bonds remain essential for diversification, income and stability. In the portion of the portfolio devoted to bonds, investors might consider increasing the percentage of municipal bonds, especially if they’re concerned about taxes. Yet as demand drives prices higher, it will be important to consider the relative value of munis versus taxable fixed income instruments. In some cases, especially for investors in lower tax brackets, Treasurys or corporate bonds may still be the better way to go.

 

“With rates and inflation rising, the Chief Investment Office currently suggests investors consider purchasing bonds with a shorter duration.”

—David Litvack, tax-exempt strategist, Chief Investment Office, Merrill and Bank of America Private Bank

Q: How can I work with my advisor to build the muni bond portion of my portfolio?

A: Investors with specific preferences could select individual bond offerings using separately managed accounts. But you would need a sizeable number of these in order to properly diversify. Mutual funds or exchange-traded funds (ETFs) generally provide greater diversification, especially for investors with a smaller amount to invest.

 

If your primary goal is income, you might consider bond laddering—buying bonds with successive maturity dates—to generate a regular cash flow and help to mitigate the risk of rising interest rates. Another consideration is credit quality. Depending on your risk appetite, you might choose somewhat lower-rated municipal bonds that offer higher yields but entail more credit risk.

 

Q: What risks should I consider?

A: Though they are typically among the safer investments, municipal bonds do carry risks. Beyond the slim but real possibility of default, bonds can lose value if the issuer’s credit rating is downgraded. Also, as with any fixed income investment, inflation can erode the purchasing power of future income. Likewise, when interest rates go up, the value of bonds declines. That’s why, with rates and inflation rising, the Chief Investment Office currently suggests investors consider purchasing bonds with a shorter duration.

 

Liquidity can be another issue. As witnessed during the early days of the pandemic, municipal bonds may be hard to sell during times of market disruption. Still, for the right investor in the appropriate circumstances, munis’ generally tax-exempt status and lower default rate, relative to corporate bonds, may make for an attractive combination. Before making any decisions, be sure to speak with your advisor and tax specialist about your tax situation, risk preferences and return requirements.

1 Source: Bloomberg Barclays U.S. Municipal Bond Index, as of May 7, 2021 

 

Important Disclosures

 

Opinions are as of the date of this article and are subject to change.


Investing involves risk including possible loss of principal. Past performance is no guarantee of future results.

 

Bank of America, Merrill, their affiliates, and advisors do not provide legal, tax, or accounting advice. Clients should consult their legal and/or tax advisors before making any financial decisions.

 

The Chief Investment Office (CIO) provides thought leadership on wealth management, investment strategy and global markets; portfolio management solutions; due diligence; and solutions oversight and data analytics. CIO viewpoints are developed for Bank of America Private Bank, a division of Bank of America, N.A., (“Bank of America”) and Merrill Lynch, Pierce, Fenner & Smith Incorporated (“MLPF&S” or “Merrill”), a registered broker-dealer, registered investment adviser and a wholly owned subsidiary of Bank of America Corporation (“BofA Corp.").

 

All recommendations must be considered in the context of an individual investor’s goals, time horizon, liquidity needs and risk tolerance. Not all recommendations will be in the best interest of all investors.

 

Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

  

Bonds are subject to interest rate, inflation and credit risks.

 

Income from investing in municipal bonds is generally exempt from Federal and state taxes for residents of the issuing state. While the interest income is tax-exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the Federal Alternative Minimum Tax (AMT).

 

Exchange Traded Funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost.

 

Mutual funds are subject to investment risks, including possible loss of the principal amount invested. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. For a discussion of the risks specific to a particular mutual fund, please refer to the fund’s prospectus.

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