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Bond Market

A Window of Opportunity with Taxable Municipal Bonds

  • 11.04.19
  • Markets & Investing
  • Commentary

Doug Drabik discusses fixed income market conditions and offers insight for bond investors.

Supply is increasing… spreads are widening! An opportunity in the niche taxable municipal bond market?

The Tax Reform Act of 1986 revoked tax-exempt status for certain types of municipal bond financing. Issuers were pressed into the taxable municipal bond market where issues are secured by the same revenue streams and tax pledges funding tax-exempt municipal bonds but subject to Federal taxes. They could be viewed as a hybrid between tax-exempt municipal bonds and corporate bonds. Taxable municipal credits are typically rated very strong (like tax-exempt municipals) yet in a much more boutique market sector than corporate bonds which are also taxed.

As depicted in the pie chart to the right, the more than $9.7 trillion corporate bonds outstanding are more than 1.5 times the $3.8 trillion municipal bonds (both taxable and tax-exempt) outstanding. Taxable bonds issued from 1996 through 2018, on average, represented 8.7% of the total municipal bond issues (see chart below). Taxable municipal bonds can allow for more diversification versus utilizing corporate issuers alone. Although taxable municipal bonds are federally taxed, many states (see Appendix A) do not tax the income generated on issues within their own states (investors residing within the state of the issuance). In addition, accretion on any discounted taxable bonds purchased in the secondary market are treated as capital gains, typically a more advantageous rate for investors versus ordinary gains (de minimis rules applied to discounted tax-exempt municipal bonds do not apply to taxable municipal bonds).

In 2009-2010, as a response to the Great Recession and in an attempt to create jobs and stimulate the economy, Build America Bonds (BABs) were introduced as part of the 2009 American Recovery and Reinvestment Act (ARRA). BABs are taxable municipal bonds that provide federal tax credits or subsidies to bondholders or state and local government bond issuers. They allowed municipalities the ability to raise capital during the recession. As shown in the chart, BABs spiked the percentage of taxable issuance in 2009 and 2010.

More recently, The Tax Cut and Jobs Act of 2017, once again changed the municipal landscape by disallowing tax-exempt status for advance refunding of municipal issues. Debt refinancing by municipalities has been a huge part of the $3.8 trillion municipal bond market. Municipalities often used advanced refunding to lower their borrowing costs when interest rates were significantly lower than the interest owed on the original bond issuance. The Tax Cut and Jobs Act of 2017 disallowed municipalities the tax-exempt advantage and thus greatly slowed advance municipal refunding.

That is until now. Interest rates have fallen to a point that is allowing states and local governments the advantage of refunding via taxable municipal bonds. Taxable debt, which is not as cost effective, is being offset by the lower interest rates. During the first 7 months of 2019, taxable municipal issues represented 8.1% of the total municipal bond issues. In August and September, they represented 19.5% and 18.5% of the total municipal issues respectively. The wave of taxable municipal issuance, is at the very least, creating a window of opportunity that is worth exploring for investors active in the taxable bond market. If rates remain in the same range, continued surge in taxable municipal issuance could continue through year end and into next year. This may mean that spreads remain wide and can provide relatively attractive yields for core investments. In addition, taxable municipal bonds offer opportunities out on the curve for investors with longer duration needs.

Takeaways on Taxable Municipal Bonds:

  • Many issues offer very high credit quality.
  • Secured by the same revenue streams and tax pledges funding tax-exempt municipal bonds.
  • Although federally taxed, many states do not tax the income generated on issues within their own states (see Appendix A below).
  • De minimis rules do not apply to discounted bonds purchased in the secondary.
  • State and local municipality issues provide taxable investors with issuer diversification from corporate issuers.
  • Widening taxable municipal spreads provide attractive comparable yields.

To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.

The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.

Stocks are appropriate for investors who have a more aggressive investment objective, since they fluctuate in value and involve risks including the possible loss of capital. Dividends will fluctuate and are not guaranteed. Prior to making an investment decision, please consult with your financial advisor about your individual situation.