ETF Trends
ETF Trends

There are some things, none of which are new to our conversation, that buttress any discussion about municipal fixed-income investing these days.

First, low interest rates generally lower the cost of financing a debt load and reduce the real debt burden for municipalities nationwide. This is a welcome story.

Second, given the United States’ present low growth rate and very low interest rate environment, the current real yield curve (Treasury yield at various maturities minus Consumer Price Index (CPI1)) in the United States is only marginally positive through the 5-year maturity and not even 2% out at 30 years. As reported by the Bureau of Labor Statistics, the CPI rose 0.8% in 2014 after a 1.5% increase in 2013. This is the second smallest increase in the last 50 years, trailing only the 0.1% increase in 2008. It is considerably lower than the 2.1% average annual increase over the last ten years.

As of this writing, the “real” yield (Treasury yield minus CPI) on quoted U.S. Treasuries was approximately:

Maturity

Treasury Yield1

CPI2

Real Yield

2-Year

0.63%

0.8%

-0.17%

3-Year

1.01%

0.8%

0.21%

5-Year

1.48%

0.8%

0.68%

10-Year

1.94%

0.8%

1.14%

30-Year

2.51%

0.8%

1.71%

 

Fortunately for investors, current inflation is low, such that yields are positive beyond two years, however, it’s important to remember that inflation can diminish yields in fixed-income portfolios.

Why do I show you this? It is to demonstrate the power of the federal tax exemption applicable to certain municipal bonds in this low interest rate, low inflation environment. The nominal yield for a 10-year AAA municipal bond, as of 2/6/15, was 1.95%. Adjust that to the maximum taxable equivalent yield (AAA yield divided by 1 minus 39.6% tax rate) and you have 3.23% for those in the highest tax bracket. This is more than a full percentage point higher than U.S. Treasuries. For a 30-year AAA municipal bond with a nominal yield of 2.75%, the same math generated a taxable equivalent yield of 4.55% as of 2/6/15, a full 2.04% more than a 30-year Treasury. Regardless of whether you reduce yields by the rate of inflation, I believe municipals remain both attractive and popular with investors.3

Finally, in the municipal high-yield space, taxable equivalent returns have outpaced most other popular investment categories for the prior ten years, proving that municipals, with the power of the federal tax exemption, deserve consideration in strategic as well as tactical asset allocation strategies.

1CPI Source: Bureau of Labor Statistics as of December 2014. A consumer price index (CPI) measures changes in the price level of a market basket of consumer goods and services purchased by households. The CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically.
2Treasury Yield Source: Bloomberg as of 2/9/2015. Note: U.S. Treasury income is exempt from state income taxes.
3Municipal Bond Yields Source: Municipal Market Data (MMD). The S&P rating scale is as follows, from excellent (high grade) to poor (including default): AAA to C, with intermediate ratings offered at each level between AA and CC. Anything lower than a BBB rating is considered a non-investment-grade or high-yield bond.