Municipal bonds are an important component in a well-diversified fixed income allocation. We recently caught up with Sylvia Yeh, co-head of municipal fixed income at Goldman Sachs Asset Management, to dive deeper into this unique bond category.
Here we challenge some popular misconceptions associated with this fixed income category, which, by the way, can translate into opportunities for a savvy active manager.
Question: What are some myths we can debunk or clarify about muni bonds?
Sylvia Yeh: There are so many! Here are the biggest misconceptions I come across often:
1. All munis are tax free.
Munis are not all tax free. Issuers of muni bonds need to meet several requirements in the federal tax code for interest on their bonds to be tax exempt. Maybe most noteworthy is that munis must be issued to finance projects or services that have a public purpose; for example, constructing a new school building. If an issuer has met those requirements, interest income is exempt from federal income tax, and sometimes from state and local taxes as well if the investor resides in the state where the bond was issued.
You’ll often hear us refer to munis as “double” or “triple” tax-exempt, meaning that your bonds can be federally and state tax exempt or exempt from federal, state and local taxes. Having said that, it is worth noting that various state rules will also govern that state exemption, so it’s important to know the state rules where you live.
There are other types of munis, however; namely, taxable munis and private activity bonds, also referred to as Alternative Minimum Tax (AMT) munis, where interest income is taxed differently than traditional munis. Taxable munis do not bear interest that is exempt from federal taxation. Interest income on these securities is subject to federal taxation and potentially state and local taxes as well. AMT bonds fall somewhere in between, as interest income is generally exempt from federal income tax, but for certain high-income earners, they may be subject to a separate tax calculation to limit certain tax benefits, thereby decreasing the value of the tax exemption on those bonds.
2. Munis are all risk free. You can’t lose money on munis.
Munis are often considered a safe investment, given their historically low default rates, and especially when compared to other fixed income asset classes like corporate bonds. But munis are not risk free.
Maybe munis were considered generally “risk free” before the Global Financial Crisis (GFC) because a large portion of the muni market was “insured,” meaning if an issuer could not make scheduled payments (of principal and interest), the insurer would step in and do so on their behalf. Municipal bond insurers unfortunately came under pressure in late 2007 and their exposure to subprime mortgages threatened their ability to pay, resulting in ratings downgrades. A risk that no one had considered materialized and transformed the muni market from a “rates” market to a “credit” market.
Each bond has a separate and distinct credit profile, which requires analysis to determine an issuer’s ability to repay. Research analysts will review security, ratings trends, financial performance, timeliness of disclosures, debt ratios, budget practices, and even economic and demographic factors when assessing the credit worthiness of a bond. While rapid credit deterioration and defaults are rare in the muni market, they have happened. Muni bonds are not created equal, and if something seems too good to be true, it probably is! There are reasons for price differentiation when comparing similar bonds; you just have to look under the hood to understand why.
Unfortunately, one can lose money on a muni bond ― there is default risk and market risk. If you own a bond of a stressed issuer that ends up defaulting on its obligation to repay you, you may lose all or some of your investment. While defaults are rare in muni-land, it’s important to know that defaults can and have happened.
If you decide to sell a bond before its stated maturity as interest rates are rising and/or the credit profile of that bond deteriorated since it was purchased, you may lose money, as the value or market value of [1]your bond may drop. If you hold a bond to maturity, however, you will not lose money so long as the underlying issuer remains in good financial health and repays its debt at the stated maturity date.
We believe these risks should not deter investors from looking at the asset class but rather encourage investors to seek professional and active management to help navigate some of these challenges and, conversely, capitalize on some of the opportunities created during times of stress.
3. Munis are not liquid.
Liquidity has changed over the years, but you need to understand inherent characteristics of the market to appreciate liquidity in the market. Munis may not be as liquid as other asset classes, but the muni market is generally a liquid marketplace.
- Munis do not trade on an exchange, and you must work with dealers to negotiate trades.
- It is true that some bonds may never trade. Roughly two-thirds of muni bonds are held by retail or individual investors who tend to buy and hold their bonds.
- You may not have two-way quoted markets available on every CUSIP. There are 50,000 distinct issuers and over 1 million CUSIPs — and munis cannot be shorted.
- Bid/ask spreads can be wider than other asset classes. Munis come in all colors, shapes and sizes. Often, smaller lot sizes will carry wider spreads than round lot positions.
Dealer participation has changed and even decreased since the GFC, in dollar terms and as a portion of the municipal market. [2] The good news here is that the marketplace continues to evolve, and liquidity is improving.
- Electronic trading platforms and direct dealer connectivity are making munis more accessible and efficient.
- While most munis remain held by the traditional retail investor, many munis are now professionally managed and not held to maturity as opportunities to optimize an investment may encourage trading securities prior to their stated maturity dates.
- There are ample CUSIPs to choose from in the muni market, so we don’t need to limit ourselves to a specific CUSIP or set of CUSIPs. Very often you will find that certain munis have similar profiles and can be interchangeable or substituted for one another.
- Bid/ask spreads have tightened reflecting better liquidity ― the result of electronic platforms becoming more relevant, advancements in technology, increased transparency, and the diversification of buyers or pockets of demand.
Fun fact: Despite concerns about liquidity, the muni market is very active, with over 50,000 trades daily representing over $13 billion in par traded.[3]
4. Munis offer lower yields than other bonds.
True, sort of. At face value, municipal yields are generally lower than other fixed income securities. That is because of the tax benefits they may offer. Remember, income on most munis is generally exempt from federal income taxes — and sometimes state and local too. After taking that into consideration, munis may even yield more than other fixed income securities.
Let’s assume the highest federal tax rate of 40.8% and do a little math.
Example: Say a muni’s yield is at 3% versus a corporate bond’s at 4% versus a Treasury bond’s at 3.5%. The 3% muni bond equates to a 5.07% yield on a taxable equivalent basis: 3%/(1-40.8%) = 5.07%
In this example, the muni bond yield is more than the yields on corporates and Treasuries and a tax equivalent basis.
5. Munis are only for the wealthy or conservative investors.
False. Munis can be interesting to many different types of investors ― we have something for everybody!
Munis are not only for the wealthy. There are different types of muni bonds with different tax features worth consideration by investors in various tax brackets. For example, if you are in a lower tax bracket, traditional federally tax-exempt bonds may not make sense for you, but maybe taxable munis do.
Yes, munis generally attract conservative investors due to their relatively lower risk profile, steady income streams, and diversification benefits, but not all munis fall into this category. Having said that, roughly 10% of the muni market is rated below investment grade and presents a different risk/reward profile.[4] For investors looking for higher income potential, seeking to benefit from inherent tax-exempt features of the asset class, and possessing a higher risk tolerance, high yield munis could be an interesting sector of the market. There are certain sectors and structures that exhibit less risk than traditional HY issuers and can present opportunities for aggressive investors. For point of comparison, investment grade munis are up 2.30% YTD,[5] while high yield munis are returning 7.5%.[6]
As a final thought, munis may be an old asset class, but they are far from boring and are definitely complex. Professional and active managers can help investors interested in the asset class optimize their exposure, outcome, and overall experience.
Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, prepayment and extension risk. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. The value of securities with variable and floating interest rates are generally less sensitive to interest rate changes than securities with fixed interest rates. Variable and floating rate securities may decline in value if interest rates do not move as expected. Conversely, variable and floating rate securities will not generally rise in value if market interest rates decline. Credit risk is the risk that an issuer will default on payments of interest and principal. Credit risk is higher when investing in high yield bonds, also known as junk bonds. Prepayment risk is the risk that the issuer of a security may pay off principal more quickly than originally anticipated. Extension risk is the risk that the issuer of a security may pay off principal more slowly than originally anticipated. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Municipal securities are subject to credit/default risk and interest rate risk and may be more sensitive to adverse economic, business, political, environmental, or other developments if it invests a substantial portion of its assets in the bonds of similar projects or in particular types of municipal securities. While interest earned on municipal securities is generally not subject to federal tax, any interest earned on taxable municipal securities is fully taxable at the federal level and may be subject to tax at the state level.
[1] Source: MSRB Muni Facts. As of March 2024: https://www.msrb.org/sites/default/files/2022-09/MSRB-Muni-Facts.pdf
[2] Source: MSRB Trends in Municipal Securities Ownership. As of June 2022: https://www.msrb.org/sites/default/files/Trends-in-Municipal-Securities-Ownership.pdf
[3] Source: MSRB Muni Facts. As of March 2024: https://www.msrb.org/sites/default/files/2022-09/MSRB-Muni-Facts.pdf
[4] Source: Bloomberg Municipal High Yield Index. As of September 30, 2024.
[5] Source: Bloomberg Municipal Bond Index. As of September 30, 2024.
[6] Source: Bloomberg Municipal High Yield Index. As of September 30, 2024.
For more news, information, and strategy, visit VettaFi | ETF Trends.
IMPORTANT INFORMATION
THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO.
Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant.
This material is provided for informational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell any particular securities or to adopt any specific investment strategy. This material is not intended to be used as a general guide to investing, or as a source of any specific investment recommendations, and makes no implied or express recommendations concerning the manner in which any client’s account should or would be handled, as appropriate investment strategies depend upon the client’s investment objectives.
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. This material has been prepared by Goldman Sachs Asset Management and is not financial research nor a product of Goldman Sachs Global Investment Research (GIR). It was not prepared in compliance with applicable provisions of law designed to promote the independence of financial analysis and is not subject to a prohibition on trading following the distribution of financial research. The views and opinions expressed may differ from those of Goldman Sachs Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and Goldman Sachs Asset Management has no obligation to provide any updates or changes.
Diversification does not protect an investor from market risk and does not ensure a profit.
Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.
Goldman Sachs has not authorized financial intermediaries to use and distribute this material, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this material is appropriate for any person to whom they provide this material in view of that person’s objective and circumstances.
Goldman Sachs does not provide legal, tax or accounting advice to its clients. All investors are strongly urged to consult with their legal, tax, or accounting advisors regarding any potential transactions or investments. There is no assurance that the tax status or treatment of a proposed transaction or investment will continue in the future. Tax treatment or status may be changed by law or government action in the future or on a retroactive basis.
Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by Goldman Sachs Asset Management to buy, sell, or hold any security. Views and opinions are current as of the date of this material and may be subject to change, they should not be construed as investment advice.
There is no guarantee that objectives will be met.
United States: In the United States, this material is offered by and has been approved by Goldman Sachs Asset Management, L.P. and Goldman Sachs & Co. LLC, which are registered investment advisers with the Securities and Exchange Commission.
Confidentiality
No part of this material may, without Goldman Sachs Asset Management’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.
© 2024 Goldman Sachs. All rights reserved.
393654-OTU-2138344