Municipal Bonds Offer Generous Yields—Especially for High Earners. Here’s How to Invest.

The effective muni yield is near 8% for people in the highest bracket in high-tax states who use a longer-term bond ladder—a rolling portfolio of bonds maturing in each of the next 10 to 20 years—in a separately managed account, according to Parametric Portfolio Associates.

“That tax-equivalent yield is just so attractive. It’s an incredible opportunity to lock that in,” says Nisha Patel, managing director of SMA Portfolio Management at Parametric.

The “locking in” aspect is an important consideration. Today’s high rates on money-market funds won’t last forever, and investors who have flooded into them face reinvestment risk. When yields dip, the income generated by money-market funds will fall, and the opportunity to invest in longer-term bonds, which rise in price when yields fall, will fade away.

It isn’t intuitive to add longer-term bonds when the Federal Reserve is raising interest rates, which it did again on Wednesday. But many strategists say the central bank is near the end of its rate-hiking cycle, which means that rates could start to fall in the next year, creating opportunity for capital appreciation in bonds.

“We believe we will see yields come down,” says Patel. “Adding duration in munis just makes more sense for investors in a high tax bracket.” Duration is a measure of interest-rate risk tied to a bond’s or bond fund’s maturity, yield, and other factors.

Jim Murphy, who heads the municipal bond team at T. Rowe Price, says he has been adding long-term munis to his own portfolio in what’s known as a barbell strategy—passing over intermediate maturities and focusing on the very short and very long ends of the yield curve.

“If you want to add duration, add it in munis,” says Murphy. “That’s what I’m doing in my own account.”

Here’s an important reason for that: The long end of the muni yield curve is where there is the most tax benefit in munis relative to Treasuries. At shorter maturities, the comparison with Treasuries, known as the muni-Treasury ratio, isn’t that attractive. But at longer maturities, munis stack up quite nicely—especially for investors in a high tax bracket.

In the two-to-10 year range, munis yield only 60% to 67% of Treasuries, Murphy says, so investing in them purely for tax reasons is worthwhile only for the very top earners. Historically that ratio averages about 75%, and munis are deemed attractive when it hits 85%. At the long end, 15 to 30 years, the ratio is near 90%.

“That’s much more compelling,” Murphy says.

One advantage of the accounts that Patel’s firm offers is that they make tax-loss harvesting easy, which lessens the pain of losses if yields continue to rise and bond values fall. Yes, selling securities at a loss to offset gains in other investments isn’t just for stocks. It works for bonds, too. In Patel’s example, if yields rise 1% in the next year, the bond ladder would decline 6% in value, but if tax-loss harvesting is used, the loss would only be 2%.

Actively managed mutual funds, by contrast, are typically much more broadly diversified than SMAs and can include some higher-yielding bonds without taking on too much risk, says T. Rowe’s Murphy. “We can use research and move into some medium-quality bonds to add yield,” he says. A ladder of 10 bonds can’t do that, and if one bond in the ladder faces a credit problem, it can dent overall performance. “Diversification and yield enhancement both favor the mutual fund,” he argues.

Closed-end muni funds, which can deploy leverage, are another option for investors interested in extending duration and benefiting from higher yields. But these funds’ prices can fluctuate more than their underlying holdings, so investors need to be able to stomach extra volatility. Closed-end fund investors can get tax-free yields over 5% and have the potential for more-significant price gains when rates fall. One highly rated fund,

Nuveen Municipal Credit Opportunities Fund
(NMCO), has a 5.5% current yield (or “distribution rate,” in closed-end parlance), lifted in part because shares trade at an 8% discount to net asset value.

There are other reasons to like munis right now. “The finances of state and local governments are in really healthy shape,” says Murphy. “They got support during Covid and in most cases have used that money wisely.”

Even if the economy weakens more than expected, munis tend to perform better in recessions than corporate bonds. This is especially true for high-yield bonds.

“Taxable high yield gets hurt in recessions,” says Murphy, who manages the

T. Rowe Price Tax-Free High Yield
fund (PRFHX), which yields 4.17%. “Correlations are less negative in our world.”

Supply-and-demand dynamics also make munis attractive: Issuance is down because rates are higher. Plus, the summer months are when many bonds are called and investors need to buy new ones. “Deals are oversubscribed, and there is more demand than issuance,” says Carney. “It is very favorable for munis.”

Patel believes that muni fund flows will turn positive in the second half of the year, adding even more support to the market. “We are viewing this to be one of the most opportune entry points for munis that we’ve seen in a long time,” she says.

Write to Amey Stone at [email protected]