Among the finest pieces of investment advice could possibly be, “It’s not what you earn, it’s what you retain that matters.” As such, lively tax management is a key piece of portfolio management. And plenty of investors use a wide range of techniques and methods to maintain Uncle Sam out of their pockets. But one strategy is usually underappreciated by many investors irrespective of what their tax bracket is.

And that’s the taxable equivalent yield on municipal bonds.

Munis provide many tax benefits over taxable bonds similar to U.S. Treasuries and corporates, chief of which is their ability to supply tax-advantaged and tax-free income. Often, investors ignore the true after-tax yield when constructing their fixed income portfolios. And that’s a shame as, as a rule, munis win out on yield.

Tax-Free Interest

Municipal bonds and debt are IOUs issued by states, local governments, and their agencies. Proceeds from these bonds will be used for a wide range of purposes, similar to special projects like light rail or the generalized funding of presidency operations. To assist spur state/local investment, Uncle Sam has been giving investors a break on taxes since 1913. The concept behind this tax exemption was to assist state and native governments enjoy a lower cost of capital for his or her funding and borrowing needs.

Other than a smaller sliver of bonds which are subject to the alternate minimum tax (AMT), most munis are free from federal taxes. And if the bond is issued by the investor’s home state, that tax break extends itself into state and native taxes as well.

This exemption on interest has been a key feature of municipal bonds, and so they have long been a portfolio holding for a lot of high-net-worth family, insurance, and institutional portfolios.

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Taxable Equivalent Yield

Nevertheless, for a lot of investors, munis are sometimes ignored completely and are simply written off as an asset class for the wealthy. The rationale? Their headline yields are paltry.

Taking a look at the most recent data from Nuveen shows that the Bloomberg Municipal Bond Index—which is a benchmark of investment-grade municipal bonds not subject to the AMT—is paying a current yield of three.7%. That’s not too bad until you compare it to other fixed income asset classes. For instance, Nuveen’s data shows that investment-grade corporate bonds are yielding 5.5%, junk is paying 7.9%, and Treasuries are paying 4.6%. Taking a look at the Bloomberg Bond Aggregate index, now we have a median yield of 5%.

Earning 5% is healthier than earning just 3.7%. With that, investors often skip munis in favor of other bonds. But by doing this, many investors are ignoring a robust advantage of munis.
And that will be their taxable equivalent yield (TEY).

A TEY is basically a return calculation that puts a taxable bond and tax-exempt muni on equal footing. It’s what you would need to earn on a taxable bond similar to an IG corporate or mortgage-backed security to make the identical after-tax rate on a muni. This calculation is essential within the investment decision and infrequently investors don’t fully appreciate its power when choosing their bond investments.

In practice, it really works like this. For somebody in the highest federal tax rate of 40.8%—37% tax rate plus the three.8% Obamacare surcharge—that low investment-grade muni yield jumps to a TEY of 6.3%. Meaning an investor would should earn greater than 6.3% before taxes to return out ahead of the muni on income generation.

Investors could do this by going into junk bonds, but then they’d be taking over way more risk. Relating to credit quality, munis often sit just under Uncle Sam by way of rating. That’s because a state or local government can raise taxes to assist pay for his or her debts. As such, most munis feature high investment-grade rankings. And in reality, many outrank investment-grade corporate bonds on credit quality.

The most effective piece is that when taking a look at TEY, the vast bulk of investors still come out ahead with munis in comparison with other bond varieties. This chart from Hartford Funds shows how much a TEY could be for investors in several tax brackets.

 
Source: Hartford Funds

With this, you may see that munis still offer loads of attractive income for investors irrespective of their tax bracket.

Perhaps one of the best piece is the TEY profit grows as bond yields rise. For instance, a 1% municipal yield increases by just 0.7% on a tax-equivalent basis. Nevertheless, a 5% municipal yield increases the TEY by 3.4%. With the Fed potentially pausing its rate-cutting path, this fact is helpful for investors in lower tax brackets. The info from Hartford’s chart was taken in September.

Already, muni yields have risen as noted by the information provided by Nuveen just a few paragraphs ago.

Investors in lower brackets at the moment are getting more income tax-free versus taxable bonds.

Specializing in Taxable Equivalent Yield

Looking strictly at headlines puts many investors—irrespective of their tax bracket—in danger for lower returns and income potential. Ignoring a TEY calculation in constructing a bond portfolio can lead to lower after-tax income potential.

One other issue? Wasting space in a tax-deferred or tax-free account on bonds versus high-growth assets like equities. Many investors could potentially have higher long-term after-tax returns by utilizing munis in a taxable account and using their IRA/401k space for equities. This is helpful for investors in lower tax brackets who can take tax advantage of Roth accounts.

Overall, munis and their ability to generate tax-free income at high credit quality shouldn’t be ignored by most investors. Getting that exposure stays the realm of funds and ETFs. Buying individual munis remains to be a tricky nut to crack and requires large investment minimums. ETFs make short work of municipal bonds and will be quickly used so as to add exposure.

Municipal Bond ETFs

These funds were chosen based on their exposure to municipal bonds at a low price. They’re sorted by their YTD total return, which ranges from 2.3% to five%. They’ve expense ratios between 0.05% to 0.65% and have assets under management between $930M to $34B. They’re currently offering yields between 1.5% and 4.1%.

Ultimately, a TEY is a robust tool that almost all investors ignore. Through the use of it, they will compare municipal bonds to many bond varieties. And it seems munis often come ahead. With strong credit quality and higher after-tax yields than most bonds, munis shouldn’t be ignored by investors of any tax bracket.

Bottom Line

Municipal bonds are sometimes ignored by investors in lower tax brackets because of their poor headline yields. Nevertheless, investors are ignoring the advantage of a TEY and muni’s high overall income when factoring in what we owe Uncle Sam. Here, it often is smart to purchase munis over other bonds.