The past few months have been an interesting time for municipal bonds. Thanks to the drama leading up to the fiscal cliff, these tax-advantaged securities were first in hot demand as a potential safe harbor against tax increases, then experienced a selloff in December amid speculation that their tax-exempt status could be removed for high-income households.
Now that much of the tax uncertainty stirred up by the fiscal cliff has been resolved, munis seem to be back in investors’ good graces.
In fact, now more than ever we may see an uptick in muni bond popularity, since tax rates have increased for all income earners in 2013. Munis tend to pay a lower yield than their corporate bond counterparts, but the income they kick off is exempt from federal income taxes. [Muni Bond ETFs: January Rebound]
So how do investors know if a muni or corporate bond offers a higher yield after taxes? By using the following formula to decipher a muni’s tax equivalent yield (TEY):
Let’s walk through an example. For 2013 the highest federal tax bracket has increased from 35% to 39.6%. Additionally, the 3.8% Affordable Care Act (“ACA”) Net Investment Income Tax* is now in effect, so the new marginal federal rate for the highest bracket is 43.4%. For an investor in the highest tax bracket this means that the TEY for the iShares National Muni Bond ETF (NYSEArca: MUB) – which currently has a yield to maturity of 1.88% – is 3.32%.
Now compare this yield with that of taxable bonds, such as the iShares Investment Grade Corporate Bond ETF (NYSEArca: LQD), which has a current yield to maturity of 3.04%. All else equal, for an investor in the highest tax bracket, the TEY of MUB is higher than the yield currently being paid by LQD. In addition, MUB’s duration is 6.09 while LQD’s is 7.75, so MUB is providing a higher TEY with lower duration risk.
But municipal bonds have historically had fewer defaults than corporate bonds, so a more apples-to-apples comparison for MUB might be higher quality corporates. The iShares Aaa-A Rated Corporate Bond ETF (NYSEArca: QLTA) holds bonds rated Aaa-A. The fund has a yield to maturity of 2.30% and a duration of 6.46. Notice that MUB is yielding over 100 basis points more than QLTA, but both are similar in duration and credit quality.
Now, this isn’t to say that MUB is the better option for every investor. It’s important to consult an expert when making any investment decisions based on taxes. It’s also key to understand the role that the bond is playing in your portfolio – if income isn’t your first priority, for example, then yield may not be the most important data point in your decision. But regardless of your strategy, when it comes to evaluating a municipal bond’s value, remember to use tax equivalent yield to put it on equal footing with taxable securities.
Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy.