There's a small portion of the bond market that investors may have overlooked but now may want to consider—the taxable municipal bond market.
Most munis pay interest that is exempt from federal and potentially state income taxes. However, interest on some municipal bonds is subject to both federal and state income taxes depending on the taxpayer's location and applicable tax law. These bonds, known as taxable municipal bonds, generally pay higher interest rates than tax-exempt munis to make up for the lack of tax benefits.
Below are some of the primary reasons we think investors should consider taxable munis. But first, a quick introduction to taxable municipal bonds:
A primer on taxable munis
The main difference between a taxable municipal bond and a tax-exempt muni is that taxable munis pay interest income that's subject to federal and state income taxes, whereas tax-exempt munis pay interest income that's generally exempt from federal and potentially state income taxes. They're often issued by the same issuer and therefore don't differ in credit quality. For example, issuers like the State of California, the New Jersey Turnpike Authority and the University of Michigan, just to name a few, all issue both taxable and tax-exempt munis. An issuer may choose to issue a bond as either a taxable or tax-exempt issue for a variety of reasons, such as the yield environment or to attract a different investor base to increase demand for their bonds.
Due to the different tax treatments between taxable and tax-exempt munis, we believe that taxable municipal bonds may be an attractive option for investors in lower tax brackets or for tax-advantaged accounts like an individual retirement account (IRA). Investors in higher tax brackets may still want to consider tax-exempt munis for taxable accounts, like a brokerage account, as they may yield more than taxable munis after considering the effects of taxes.
Five things to know
1. Taxable munis offer attractive yields relative to tax-exempts.
Yields for taxable municipal bonds are attractive, in our view, compared to tax-exempt munis of similar maturities. For example, since January 2010, on average, an index of taxable municipal bonds has yielded 1.0% more than an index of tax-exempt municipal bonds. Only during a brief period in March 2020 when the market was very volatile due to the onset of the COVID pandemic crisis did taxable munis yield less than tax-exempt munis. Today, that difference is near the highest since 2015.
2. Taxable munis are generally high in credit quality, like tax-exempt munis.
Another potential benefit of taxable munis is that they're generally higher in credit quality than other alternatives. For example, 82% of the taxable muni market is rated in the top two rungs of credit quality–AA minus or above.1 This compares to 78% for the tax-exempt muni market and only 8% of the corporate market, as illustrated in the chart below.
This is notable for investors because higher-rated issuers tend to default—that is, to miss an interest or principal payment—less frequently than lower-rated issuers. For example, over a five-year period ending in 2023, 0.2% of Baa rated munis defaulted, according to Moody's Investors Service. During the same period, lower-quality B rated munis defaulted 18 times more often, at a rate of 7.3%.
Moreover, municipal bond issuers, which include issuers of taxable munis, tend to default less frequently than corporate bond issuers. Looking at the Baa rated cohort, the default rate for munis was 0.4%, compared with 1.5% for corporates.
3. Taxable munis historically have performed well.
Since the end of 2009, an index of taxable munis has returned an average annual total return of 4.9% outpacing corporates, Treasuries, and tax-exempt munis. However, this is an average and can substantially vary by year. For example, since the end of 2009, the best 52-week total return for taxable munis was just shy of 25% while the worst 52-week total return was just over -22%. In other words, on average, total returns for taxable munis are better than corporates tax-exempt munis, and Treasuries but the volatility is greater too. Total return is composed of the yield that an investor receives as well as any price fluctuations. The yield component has generally been the largest driver of total returns over time. This bodes well for future total returns because yields today are elevated and can help buffer any negative price changes.
However, taxable munis do have some risks. Here are two of the most prominent:
4. The relatively small size of the market could pose liquidity problems.
The amount of newly issued taxable munis has been declining recently. Couple this with the fact that the taxable muni market is much smaller than many other fixed income markets, as illustrated in the chart below, and investors may have a find time finding enough taxable munis to achieve adequate diversification. Additionally, smaller markets are generally less liquid than larger ones, like the Treasury market, which means that it can be more difficult to sell your bond if you need to. Therefore, we suggest that if you're considering taxable munis, plan on holding them until maturity. The smaller market and lower liquidity of taxable munis is also an issue for investors in funds like exchange-traded funds (ETFs) or mutual funds.
Due partly to the size of the market, there aren't many mutual funds or ETFs that invest solely in taxable municipal bonds. In fact, there is only one open-ended ETF that we know of that invests in taxable municipal bonds and doesn't use leverage. Leverage generally means using borrowed funds to try to amplify returns. However, leverage can also amplify negative returns. Bonds that are less liquid are generally more volatile in times of market stress.
5. The taxable muni index is sensitive to interest rate changes.
First, the taxable muni index has a longer average duration—which makes it more sensitive to changes in interest rates—than the tax-exempt index. For investments such as ETFs or passively managed mutual funds that simply track the index, investors are taking on greater interest rate risk with taxable munis compared to tax-exempt munis. This is important because if rates rise more than we expect, total returns for taxable munis would likely underperform their tax-exempt counterparts even more.
What to consider now
For investors in high tax brackets, we generally don't see value in taxable munis. However, investors in lower tax brackets or those investing a tax-sheltered account like an IRA may want to consider a small allocation to taxable munis to complement their other fixed income holdings.
Schwab clients can log in to their accounts and search for individual taxable munis. If you need additional help, reach out to a Schwab Fixed Income Specialist for guidance in selecting the investments that are right for you.
1The Moody's investment grade rating scale is Aaa, Aa, A, and Baa, and the sub-investment-grade scale is Ba, B, Caa, Ca, and C. Standard and Poor's investment grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C. Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. Fitch's investment-grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C.
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