This month’s snapshot of the municipal bond market from the Wells Fargo Asset Management Municipal Fixed-Income team focuses on opportunities in crossover taxable markets:
- Cross-market relative value shows that taxable credits continue to offer relative value. The yields on taxable muni bonds have widened compared with their tax-exempt counterparts.
- Meanwhile, muni credit continues to perform better than corporate credit, resulting in after-tax yields of certain corporate issuers that look significantly more attractive than the tax-exempt yields of muni bonds.
To start, here’s an infographic highlighting recent muni bond trends:
Worth a look: Taxable muni bonds
The difference between taxable and tax-exempt muni yields has widened over the past year, which could make them attractive to some investors willing to consider taxable muni investments. Although yields on both taxable and tax-exempt have declined, taxable muni yields have remained at higher levels.
For example, comparing California state general obligations (GOs) with six-year maturities, the chart below shows a 60-basis-point (bp; 100 bps equals 1.00%) difference between taxable muni yields of 2.63% and tax-exempt muni yields of 2.03% in May 2015. At the end of February 2016, taxable yields were 2.18% in contrast to tax-exempt yields of only 1.15%, a difference of 103 bps. Adjusting the taxable yield for a 35% tax rate would equal a 1.42% tax-exempt equivalent yield—a 27-bp advantage for the same maturity and credit-quality investment.
Corporations are finding it cheaper to issue tax-exempt debt than taxable debt
In select cases, corporate debt is trading with cheaper after-tax valuations (higher yields) in the corporate debt market than in the tax-exempt corporate-backed sector. When taxable spreads become wider and valuations become cheap from a historical perspective, it may be an attractive opportunity for tax-exempt investors to cross over into the taxable market in pursuit of higher after-tax total returns. (We wrote about this in last month’s blog post, and we continue to find taxable securities that offer relative value for muni investors.) On the flip side, several firms issued tax-exempt prepaid gas bonds (a type of industrial development revenue/pollution control revenue bond) in February seeking to take advantage of the cheaper financing due to low yields in the tax-exempt muni market.
Not all muni debt is cheap
Muni debt has been performing well and therefore is relatively more expensive. This is why opportunities in taxable muni debt and taxable corporate debt exist. Looking at muni bond yields compared with Treasury yields, it’s apparent that shorter-term munis remain expensive. Investor demand is strong, especially for uber-liquid variable-rate demand notes, a type of maturity whose coupon resets every seven days. Issuance of short-term notes, such as revenue anticipation notes, has been limited due to better financial health in many U.S. states, which do not need to issue debt for cash-flow purposes.
The benefit of focusing on after-tax returns
After-tax considerations have become increasingly important when evaluating options in the tax-exempt muni, taxable muni, and corporate debt markets. By expanding the investment set to include nontraditional markets, tax-exempt investors seeking higher after-tax total returns can capture relative value across these markets. However, as a relative-value strategy, a tax-exempt investor’s exposure to taxable bonds will likely be limited in time (the opportunity will eventually wane as historical valuations reappear) and magnitude (an issue-selection decision rather than a larger-size sector allocation.) Active managers should be best positioned to find relative value in similar maturity and credit-quality debt instruments across these markets and then determine the appropriate time to exit.