Municipal Bonds vs. US Treasury Bond Yield Comparison

As a follow-up to my post on the risks of investing in bonds, I should share that a slight majority of my personal bond holdings are in short-term and intermediate-term municipal bonds. Why? Well, here are some considerations if you are choosing between holding highly-rated municipal bonds and US Treasury bonds right now.

The Blackrock Blog has an article discussing potential effects of tax reform on muni bonds and also their latest Municipal Market Update [pdf]. Here is my interpretation of their points:

Lower individual tax rates would reduce the value of tax-exempt mutual fund income. However, the tax equivalent yield (TEY) of municipal bonds would likely remain higher than that of Treasuries. The calculation is straightforward. For example, at a 28% marginal tax rate, if a municipal bond earned 2%, that would be a tax-equivialent yield of 2/(1-0.28) = 2.78%. Here’s the chart from Blackrock:

It is highly unlikely that the tax-exempt status of municipal bonds will be removed. State and local government need low-cost muni bonds to finance improvements in infrastructure. It is possible that the tax-exemption could be capped, but even in that case the market impact would be manageable.

Here’s the ratio of AAA-rated GO Muni bonds to Treasuries over the last 12 months (Source). As you can see, the ratio hovers around 90% to 95% without compensating for taxes.

Here is a chart of the muni and Treasury bond curves as of 1/31/17:

Their overall conclusion:

We also expect any market correction required to overcome a drop in the highest tax rate or cap on the tax-exemption would be manageable, and continue to believe munis hold an important place in a diversified portfolio.

Purely my opinion… I don’t bother speculating on future tax reform. I’m not an economist, so I can admit that I don’t know the future. I do know that even in the 25% or 28% marginal tax brackets, right now the tax-equivalent yields of muni bonds are higher than Treasuries by a significant gap. At higher marginal tax brackets, the gap widens further (again, see top chart above).

Municipal bonds are not considered as safe as US Treasuries, and smart people can argue as to how close the risk levels are. I personally think the yield gap is greater than the risk gap, enough that I’d rather be in munis, but others may disagree. Why would this happen in a mostly “efficient” market? My personal view is that the entire world (including entire countries and sovereign funds) relies on US Treasuries as their “safe and liquid” asset, pushing yields downward, while the benefits of muni bonds are only available mostly to US individual taxpayers.

Sometimes I think I should just buy a “total bond” fund (tracks all taxable, nominal US investment grade bonds) and forget about it. But then I look at the yield difference. As of today 2/21/17, Vanguard Total Bond Index has an average duration of 6.1 years and 2.50% yield. Vanguard Intermediate Tax-Exempt has an average duration of 5.2 years and 2.07% yield (tax-exempt). At 28% federal tax rate, that is equivalent to 2.88% taxable. At 43.4%, that is equivalent to 3.65% taxable. (These numbers are for Investor Shares; the gap is even bigger if you have $50,000 and can buy Admiral Shares.) Add in the fact that I have limited space in tax-deferred IRAs and 401(k) accounts, and all this is why I pick munis for my taxable accounts.