The municipal bond market is unlike any other fixed-income market in numerous ways. It’s a $4 trillion market with millions of individual bonds and credits that trade on an over-the-counter market, which means there is no centralized market like Treasury or corporate bonds. The tax-exempt nature of its dividend stream also adds another layer of confusion as the returns may seem lower, but to the tax-savvy investor, the tax-exempt status offers great value. Additionally, the historical credit quality of the municipal bond market has been strong with a lower default rate than corporates and fewer rating downgrades.
The Positive and Negative Aspects of an Over-the-Counter Market
An over-the-counter market simply means there is no centralized trading platform. When an investor wants to buy an equity, they just call their advisor and put in an order. The order is then transmitted to a market maker in the security and executed. Buying a municipal bond is much more complicated as there are millions of different bonds and no centralized market maker.
The advisor must search various broker dealers and have a full understanding of the intricacies of the market to purchase a security with the best value. The same bond could be offered by various dealers at different yields and not understanding the fragmentation of the market could easily lead to making a mistake. Taking full advantage of the market requires a professional manager skilled in municipal bonds.
Understanding Tax-Equivalent Yields
While yields on municipal bonds may initially seem lower than taxable yields such as treasury or corporate bonds, an investor must consider the tax-free nature of municipal bonds. Investing in taxable bonds adds a layer of income tax not applicable to municipal bonds, and investors get to keep what they earn instead of paying income tax. A tax-equivalent yield is a calculation that estimates the taxable yield an investor needs to match the lower yield of a municipal bond. For example, based on the top tax rate an investor earning a 2.25% tax-free yield would have to purchase a taxable bond at approximately 3.80% to have the same after-tax return. While the 2.25% is achievable in the tax-free bonds, an investor would have to take on significantly more risk to purchase a taxable bond at 3.80%.
Credit Quality of Municipal Bonds
Credit quality is a major component of municipal bonds as approximately 75% of the market is rated A+ or better and approximately 10% is below investment grade. Compare this to the corporate market which is only 10% A-rated or better and is over 40% non-investment grade.1
In addition, municipal bonds have a stronger credit profile than corporates since the bonds are typically secured by inelastic services including water, sewer, healthcare, and education and not by individual corporations that are affected by many different economic and internal circumstances.
What is the Best Way to Invest in Municipal Bonds?
SWBC Investment Company has extensive municipal experience and unique strategies to not only maximize an investor’s income but also capitalize on the inefficiencies of the market to help investors utilize their assets effectively.
Moody’s Investors Service, U.S. Municipal Bond Defaults and Recoveries 1970-2019.
Securities offered through SWBC Investment Services, LLC, a registered broker/dealer. Member FINRA & SIPC. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor, registered as such with the US Securities & Exchange Commission. SWBC Investment Services, LLC is under separate ownership from any other named entity. SWBC Investment Services, LLC a division of SWBC, is a nationwide partnership of advisor.
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