The big opportunity in these tax-free bonds is 'closing and closing fast,' strategist says

CNBC

05-05-2025

This could be a fleeting moment in time to snag excellent income in municipal bonds, according to several strategists. Muni bond prices slipped in April amid tariff-induced market volatility, with the Vanguard Tax-Exempt Bond ETF (VTEB) dropping about 0.9% last month. Bond yields move inversely to prices. Higher net-worth investors typically turn to muni bonds because their interest income is free of federal tax and exempt from state tax when the holder lives in the state in which the bond is issued. "The top opportunity for municipal investors remains, but it is closing and closing fast," Tom Kozlik, head of public policy and municipal strategy at Hilltop Securities, wrote in a note Friday. "The potential for falling interest rates due to economic weakness presents a compelling argument for investors to seize this fleeting window of opportunity." The Vanguard Tax-Exempt Bond ETF currently has a 30-day SEC yield of 3.93% and an expense ratio of 0.03%. VTEB YTD mountain Vanguard Tax-Exempt Bond ETF Not only are yields attractive, but municipal bonds look cheap compared to Treasurys, said Richard Saperstein, chief investment officer at investment firm Treasury Partners. These days, munis are offering attractive relative value, he said. "This becomes an outstanding opportunity," Saperstein added. The sell-off in munis had to do largely with technical factors, like elevated supply and selling into tax season, as well as the stock market decline, he said. He agrees that the chance to grab these yields isn't going to stick around. "They'll be here until it's not," Saperstein said. "This will disappear without any warning, because the absolute relative levels of municipal bond yields are so attractive, they will disappear as soon as the supply congestion clears itself up." Bank of America is predicting yields shouldn't shift too much in the first two weeks of May. The firm expects the key driver to be April's consumer price index data, set to be released next Tuesday. "Munis should outperform Treasuries in May given the more balanced supply/demand environment and cheap muni ratios," strategist Yingchen Li wrote in a note Friday. "We like 10yr area high grade munis for performance in the coming months." Vanguard portfolio manager Grace Boraas sees a number of benefits for muni bond investors this year, including attractive tax-equivalent yields of around 7% for average investors — and north of 9% for those from high-tax states like California and New York. Tax-equivalent yield refers to the yield a taxable bond needs to generate in order to be equal to that of a tax-free bond. Consider that a single filer in the 24% federal income tax bracket who has a muni bond with a tax-free yield of 3% would have to shop for a taxable investment with a yield of 3.95% in order to generate a comparable level of income. Boraas said that muni bonds' historical ratio to Treasurys may stay cheap for the foreseeable future. She was referring to the municipal bonds to Treasury yield ratio, which compares rates on issues with similar maturities. "Eventually we expect that once the uncertainty in the market calms down a little bit, those ratios will normalize and provide a good tailwind from a performance perspective," she said. On top of that, fundamentals remain strong. "The municipal market, fundamentally, is doing very well. And then additionally, for state and local governments, they have an ample rainy day fund," Boraas said. "As we see the picking up of potential recession risks in the economy, fundamentally speaking, munis are very well positioned to weather that storm." Those high yields also provided a nice cushion during the latest sell-off, Shannon Rinehart, senior portfolio manager of municipal debt at Columbia Threadneedle Investments, pointed out. MUB YTD mountain iShares National Muni Bond ETF "The sell-off has been mitigated. This is different from 2022 because of where we are starting," she said. "Starting point matters for fixed income, and … despite the sell-off — which was pretty extraordinary, historically the second worst sell off we've ever experienced in the muni market — we are still seeing positive returns in the very front end." "What municipals are still providing is that buffer that folks look to for their fixed income investments," she added. While sell-offs can happen swiftly, the recovery takes a bit more time, Rinehart noted. Where to find opportunity Treasury Partners' Saperstein focuses on general obligation bonds, which are backed by the full faith and taxing power of the authority. He finds toll roads attractive, as well as transit systems, water and sewer districts and other general essential services bonds. While buying bonds within your home state will give you a local tax break, Saperstein advises not putting 100% of your portfolio there. "We want to spread the risk of being concentrated in one state in case there's a tail-risk event," he said. "Many times for investors that are in a high-tax state, by diversifying, you actually get a higher yield on a pre-tax basis, and after paying the taxes, you're equivalent or even better off than buying a municipal bond from your home state." Meanwhile, Columbia Threadneedle's Rinehart is finding opportunity amid a bifurcated market. For instance, she is overweight hospitals, but likes urban primary providers versus rural providers. That's because rural hospitals have a higher level of Medicaid payers, she said. "They are running on very, very thin boot straps as it is," she said. "If you talk about Medicaid being reduced and or large portions of their population losing Medicaid completely, it's just not a very viable business model." Rinehart also likes the premium in AMT bonds — those subject to the alternative minimum tax. These bonds spin off interest income that is subject to federal taxes if the AMT also applies to the taxpayer who owns the bond in a taxable account. The AMT applies to a small number of high-income taxpayers.