Municipal bonds are still standing on firm fundamental ground.
Municipal bonds have long been attractive for investors in high tax brackets, and investors should not dump them now. On an aftertax basis, muni bonds tend to offer solid income streams because their interest payments are exempt from federal taxes. But these benefits could diminish if tax rates come down, which looks like a real possibility in the wake of the U.S. presidential election. This risk led to 10 weeks of outflows from municipal-bond funds after the election. But it would be premature to abandon muni investments at this juncture. First, the implications of the new administration's proposed tax reforms are not as dire as investors might believe. Second, municipal bonds are some of the better-performing, lower-defaulting credit instruments. Finally, and most importantly, the state economies that back the credits of municipal bonds are on a solid fundamental footing.
Municipal bonds are obligations issued by state and local governments to finance their operations and fund public projects such as schools, hospitals, and roads. Broadly, there are two kinds of municipal bonds--general obligation and revenue--which are distinguished by the source of cash flows used for interest and principal payments. General-obligation bonds are backed by various tax sources such as property and income taxes. Revenue bonds draw cash flows from specific projects such as airports and bridges. Revenue bonds tend to offer slightly higher yields because they can't access the broader tax base, increasing their credit risks.
Generally, interest earned from a tax-exempt muni bond is not taxed at the federal level. In some instances, it is even exempt at the state and/or local levels, depending on an investor's residency. As a result, most intermediate and long muni funds offered a better tax-equivalent yield to maturity than the Bloomberg Barclays U.S. Aggregate Bond Index's yield as of January 2017. This is the yield that a taxable-bond fund would need to offer the same aftertax return as the muni-bond fund's yield. So, muni bonds have been popular to investors who are in high tax brackets.
Though far removed from becoming a law, the new administration's proposed tax reform aims to lower individual tax rates, making muni securities less appealing. But the actual implication for muni bonds is less severe than how it may first appear. The current proposal is to lower the individual tax rate from the current average of 34% to 28%. Under this scenario, the average tax-exempt yield for 10-year and 30-year investment-grade municipal bonds would need to increase by approximately 26 basis points and 28 basis points, respectively, to offer the same tax-equivalent yield, per J.P. Morgan's 2017 Municipal Market Outlook report that was published in November 2016. In short, the potential effect of the proposed tax cut is relatively small, and it should not be a basis for exiting the asset class.
Furthermore, despite political uncertainty, municipal bonds are standing on firm fundamental ground. As investors face a range of possible future policy outcomes, it is especially important to understand the underlying credits that back municipal bonds. According to Moody's, municipal bonds have defaulted less than comparable corporate bonds over the past four decades, as shown in the table below.
Improving state budgets should continue to keep muni default rates low. Growth in population and housing prices coupled with falling unemployment rates are likely to boost local and state revenues. The U.S. employment rate for adults of prime working age (25 to 54 years old) reached 75.1% as of June 2016, a 2.5% change since 2007. The largest municipal-debt-issuing states, California and New York, recorded 75.0% and 76.4% employment rates, respectively, an increase of more than 3% since the recession, according to The Pew Charitable Trusts.
More broadly, the 15 largest states experienced a median population growth of 4.1% from 2011 to 2015 and a median household income growth of 5.5%, based on studies by Moody's, the U.S. Census Bureau, and Bloomberg. California and New York had population growth of 5.08% and 2.16%, respectively, over the same period. The median household income for both states improved by 1.3% as well. Moreover, state property tax revenues grew 3.6% year over year as of June 2016, the highest growth rate since June 2009. Since 2012, national home prices jumped by 41.6% through June 2016, boosting property tax revenues along the way, per J.P. Morgan's 2017 municipal market report. This growth helped fuel an increase in property tax revenues, which make up roughly 80% of local government revenues.
While state budgets are improving, there are still risks. Pension costs remain a key risk factor for several states. Moody's projects that state pension liabilities will reach $1.75 trillion by 2017. Illinois, New Jersey, and Connecticut are especially underfunded and face potential downgrade risks. In addition, U.S. territories such as Puerto Rico and the U.S. Virgin Islands are struggling amid a decline in tourists and faltering local economies.
Vanguard Tax-Exempt Bond ETF VTEB, which has a Morningstar Analyst Rating of Silver, is a persuasive option for investors looking to gain broad exposure to the investment-grade, tax-exempt U.S. municipal-bond market. With an expense ratio of 0.12%, this exchange-traded fund is one of the lowest-cost options in the municipal-national intermediate Morningstar Category and it has tracked its benchmark tightly. Moreover, it excludes debt issued by Puerto Rico and other U.S. territories. The fund's market-cap-weighted portfolio construction skews it toward the most-heavily-indebted issuers. The fund's exposure to California and New York is approximately 75% larger than the category average. However, these states are supported by improving local economies. Still, any state-specific adverse event, such as a natural disaster or political turmoil, can have an outsize impact on the fund. Also, the fund's duration is slightly under six years, making it fairly sensitive to rate movements.
Vanguard Limited-Term Tax-Exempt VMLUX takes less interest-rate risk than VTEB. This fund invests in high-grade bonds with less than five years until maturity. The expense ratio for the Admiral shares is the same as VTEB at 0.12%, and the same team manages the fund. But unlike VTEB, this fund is actively managed. This active fund uses a "hub and satellite" approach. The hub incorporates the team's macro view on interest-rate, yield-curve, and credit risk. The satellite makes tactical adjustments, seeking to add value through five sources: portfolio construction, security selection, subsector allocation, curve positioning, and implementation.
As of January 2017, the team was taking slightly more interest-rate risk while assuming less credit risk than its category peers. The resulting portfolio offers a similar yield to its muni-national short category peers. The fund has historically had a conservative portfolio compared with its peers, which has helped it weather market downturns better than most. The fund carries an Analyst Rating of Silver.
Investors who can stomach greater interest-rate risk in exchange for greater return potential might consider PowerShares National AMT-Free Municipal Bond ETF PZA. This fund invests in investment-grade, tax-exempt U.S. municipal bonds with maturities of 15 years or longer. As a function of its long-duration mandate and the minimum eligible deal size of $25 million, this fund tilts toward revenue bonds, especially transportation and water and sewer issuers, and they have helped boost the fund's yield. These sectors make up about half of the fund's assets, double the exposure of its typical peer in the muni-national long category. The muni-bond market's supply dynamic drove the fund's recent outperformance. It generated an annual return of 5.5% over the trailing three years through January 2017, ranking in the top 5% of the category.
Municipalities have refinanced their obligations at lower rates, reducing the supply of long-dated, higher-yielding bonds, while pushing the values of the existing issuances favored by this fund. However, this refinancing activity may not continue if rates rise. Also, PZA's expense ratio of 0.28% is higher than the shorter-term VTEB and Vanguard Limited-Term Tax-Exempt. Unless investors are targeting a specific interest-rate risk profile, VTEB is probably the best option for broad exposure to muni bonds.
Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.