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CNBC
01-07-2025
- Business
- CNBC
Scoop up tax-free yield and keep price fluctuations in check with these bonds
An opportunity is taking shape within the world of tax-free bonds – and it may offer investors some outperformance if they're careful. Municipal bonds are beloved by high income investors as they spin off interest income that's free of federal taxes. They're also tax-exempt on a state basis if the investor resides in the issuing state – a feature that can provide meaningful savings in high-tax locales like New York and California, where top income tax rates are 10.9% and 13.3%, respectively. Retail investors have also been jumping into the space as of late, with Vanguard's Tax-Exempt Bond ETF (VTEB) scooping up $1.9 billion in inflows over the past month. Year to date, the fund has seen more than $2.7 billion in flows. VTEB has a 30-day Securities and Exchange Commission yield of 3.87% and an expense ratio of 0.03%. Even as tax-advantage yield may be attractive, investors may be missing out if they stick solely with muni bonds that are short in duration – meaning that they have less price sensitivity to changes in interest rates. Fixed income assets with short duration also tend to have shorter maturities. The upshot is that they offer solid yield when interest rates are high. However, they don't see as much price appreciation once the Federal Reserve dials back rates. Bond yields and their prices are inversely related, and longer-duration issues tend to have the greatest price sensitivity when rates fluctuate. "The crowd mentality that's driven by fear is heading to the front end of the yield curve," said Stephen McFee, senior portfolio manager at Vanguard. "They are running from that duration risk. The overlooked part of the market is the long-end part of the market." "Don't shun the long end. That's where we see value now," he said. McFee is also portfolio manager on Vanguard's Core Tax-Exempt Bond ETF (VCRM) , which has an average stated maturity of 14.4 years, but an average duration of 7.3 years. The fund has a 30-day SEC yield of 4.07%, and an expense ratio of 0.12%. A sensible approach to managing duration Adding duration to municipal bonds has also been the rallying cry at Bank of America, where strategists have been calling for a reacceleration in the muni market rally both near term and in the rest of the year. One of the reasons behind that is because headlines around tariffs aren't as shocking as they were in April – and that means that even when the 90-day reprieve on the steepest of President Donald Trump's tariffs ends next week, bonds may not see yields spike the way they did earlier this year, according to Yingchen Li, municipal research strategist at Bank of America, in a June 6 report. In a June 27 report, the Bank of America muni team said it's overweight single-A and triple-B municipal bonds, and it's sticking with its suggestion that investors add duration exposure. That doesn't necessarily mean to load up indiscriminately on the longest-dated municipal bonds, however. Active managers seem to largely be focusing on the intermediate part of the muni bond curve – that is, the 3- to 7-year part of the range – and being careful with duration, said Shannon Saccocia, chief investment officer - wealth for Neuberger Berman. This intermediate duration offers yield and the opportunity for price appreciation – but the swings aren't as dramatic as what would likely show up on the issues with longest durations. "While there's some hesitation on duration, taking a little bit of it – especially that 3- to 7-year range – and given the attractive pricing right now, it's not something to be overly concerned about," she said. "If you're looking under the hood, and you're in a double-digit duration, maybe you'll want to ask some questions, but active managers are managing that duration risk pretty well," Saccocia added. Customizing duration Investors who snap up individual muni issues for a customized portfolio can work with an advisor to determine the average duration they should have – and they can sit tight through fluctuations in prices because they are waiting for maturity. Those who use mutual funds and exchange traded funds to address their muni bond needs, however, have the benefit of liquidity — and they can get exposure to the space with fewer assets. Still, they'll see plenty of price fluctuations in the meantime. In that case, investors may want to consider working with an advisor to pair a short-duration muni bond fund with a long-duration counterpart, said Blair duQuesnay, certified financial planner at Ritholtz Wealth Management in New Orleans. "You would start with what average duration you want to have, and you blend the two," she said. "The advisor needs to be aware of what strategy is used in each fund. But if you start with 'What duration am I comfortable with?' The ratio of the two funds is based on what you want this average duration to be."
CNBC
05-05-2025
- Business
- CNBC
The big opportunity in these tax-free bonds is 'closing and closing fast,' strategist says
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.
