Do taxable bonds belong in a tax-exempt portfolio? It’s not a trick question. With taxable muni bond issuance reaching $160 billion year-to-date (188% more than total 2019 issuance)1, we think the answer is clear: Yes.
The steady pace of taxable municipal issuance will likely put year-end gross issuance in the entire muni market close to $450 billion, which would be the highest amount since 2017. The surge also looks likely to result in an annual net muni issuance totaling approximately $115 billion, bucking a decade-long trend that has seen meager annual net issuance2.
The surge in taxable bonds has a lot to do with a provision in the 2017 Tax Cuts and Jobs Act that disallowed tax-exempt advance refunding by muni issuers. With US Treasury yields near historic lows, many issuers went ahead and opted to refund existing tax-exempt bonds with taxable municipal debt. Tax-exempt supply, on the other hand, has been limited by the change in refunding rules.
In our view, there are a few reasons why this should matter to municipal bond investors.
After-Tax Income Opportunities: The way we see it, it’s what you keep that counts, and in a yield-starved world, taxable municipals may help investors keep more after taxes. Consider the Minnesota taxable general obligation bond in exhibit 1. Even in the highest tax-bracket, this security out yielded comparable tax-exempt munis. At lower tax rates, the after-tax yield advantage was even greater.
Source: GSAM. The above example illustrates State of Minnesota taxable and tax-exempt issues that both came to market on August 11, 2020. These issues were selected because it is a well-known entity which recently issued both types of bonds on the same day. *Assumes the maximum stated federal tax rate of 37% plus the 3.8% Affordable Health Care Tax. The gross yield of an investment is its income before taxes and expenses are deducted. For illustrative purposes only. There can be no assurance that the same or similar results to those presented above can or will be achieved. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this document. Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or its securities. Past performance does not guarantee future results, which may vary.
We think investors should regularly monitor the relationships between tax-exempt munis and taxable bonds, such as US Treasuries and taxable munis. Muni issuers may have debt outstanding in both the taxable and tax-exempt markets. Depending on an investor’s individual tax rate, the potential after-tax yield may be higher on a taxable muni than a tax-exempt one.
Improved Liquidity: The increase in taxable supply has attracted investors who don’t typically buy municipal bonds. These “cross-over” buyers may play a key role in future market dislocations, providing liquidity in times when muni mutual funds experience outflows. They may also raise longer-term demand for tax-exempt munis.
Broader Diversification: Until recently, the majority of taxable munis were Build America Bonds issued in 2009 and 2010 that carried tax credits and federal subsidies for bond issuers or bondholders. Most had long maturities. The newer supply is more diverse from both an issuer and maturity perspective. This has provided taxable investors with more opportunities along the yield curve and a more diversified pool of issuers and sectors to choose from.
Source: GSAM, Bloomberg, J.P. Morgan. As of September 29, 2020. *Other bucket includes the 22 sectors that each account for less than 3% of total issuance. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this document.
The muni market is evolving, and we think taxable munis will be with us for a while. In our view, traditional muni investors who can add taxable munis to a tool kit that also includes broad yield-curve positioning and selective exposure to credit may increase their investment opportunity set.