Investors See Opportunities in Taxable Munis
The taxable municipal bond market is attracting buyers as the tax-exempt municipal bond market and other taxable asset classes look expensive.
Investment opportunities in the taxable municipal bond market may also arise for investors as taxable issuance is up over 50% this year versus the first two months of 2012.
“Taxable munis are definitely attractive,” said Eric Friedland, head of muni research at Schroders Investment Management, adding the firm’s U.S. taxable fixed-income groups are paying attention to them. “They have incrementally increased allocations to taxable municipal bonds this year and are bringing taxable munis into other non-U.S. portfolios in the firm.”
He said one reason why many firms are adding strategic allocations to taxable munis is that there is more recent issuance.
“There are situations where universities and municipalities are using taxable bonds to refund tax-exempts because there are restrictions on how any times an issuer can refund tax-exempts, but there aren’t restrictions on taxable refunding.”
With rates so low, issuing taxable municipal bonds makes sense in this environment, Friedland said, adding: “Absolute and relative rates are so low that the economic benefits of refunding tax-exempts with taxables outweighs the costs.”
Yields on triple-A taxable munis have jumped so far this year, according to the Municipal Market Data scale. The five-year yield increased to 1.15% on March 1 from 1.03% on Jan. 2.
The five-year yield hit its highest on Jan. 31 at 1.35%. The 10-year triple-A taxable yield increased to 2.46% from 2.41% at the beginning of the year. It hit its highest of point the year at 2.63% on Feb. 19. Similarly, the 30-year yield jumped to 3.83% from 3.80% at the start of 2013. It hit its highest of the year at 3.99% on Feb. 19.
Triple-B taxable munis have also seen a small selloff. The two-year jumped to 2.44% on March 1 from 2.38% at the start of 2013. The five-year yield jumped to 3.40% on March 1 from 3.29% at the beginning of the year. To be sure, yields on the long end have rallied. The 10-year triple-B taxable muni yield fell to 4.79% from 5.06%, while the 30-year fell to 5.87% from 6.05% at the start of the year.
Yields on other taxable asset classes have risen as well, though not as much as taxable muni yields, allowing the spread to widen.
The spread between the two-year taxable triple-A MMD yield and the two-year Treasury widened to 25 basis points on March 1 from 14 basis points on Jan. 2. Similarly, the five-year triple-A taxable MMD yield and the five-year Treasury widened to 40 basis points from 27 basis points at the beginning of the year. Similarly, the 10-year spread widened to 61 basis points from 57. The 30-year spread widened just slightly to 77 from 75 basis points.
Further down in credit quality, the spread between the two-year triple-B taxable MMD yield and the corresponding Treasury yield widened to 220 basis points from 212. The five-year spread widened to 265 basis points from 253 at the beginning of the year.
Spreads on the long-end have compressed as investors move out in duration in search for yield. The spread between the 10-year triple-B taxable MMD yield and the corresponding Treasury yield compressed to 294 basis points from 322 basis points. The 30-year triple-B taxable MMD yield and the corresponding Treasury yield compressed to 281 basis points from 300 at the beginning of the year.
Taxable munis also look attractive relative to corporate bonds as spreads have widened over the course of January. “The way corporate spreads have tightened over last six months to a year, taxable munis are still offering attractive opportunities on a relative basis,” said Peyton Studebaker, vice president at Caprin Asset Management.
He added that taxable munis look attractive on a comparable rating basis. “If you look at a double-A-rated county GO deal in a state like Virginia that was issued on the taxable side versus a double-A-rated corporate bond, you can pick up 15 to 20 basis points in the front-end of the curve,” he said.
Spreads between the two-year triple-A MMD taxable muni and the two-year triple-A corporate bond widened to negative one basis point on March 1 from negative 18 basis points at the start of 2013. The five-year spread widened to negative one basis point from negative 14 basis points on Jan. 2. Similarly, the 10-year spread widened to negative one basis point from negative 21 basis points at the start of the year.
Moving down the credit scale, triple-B taxable munis look even more attractive relative to triple-B corporates. Spreads on the two-year widened to 84 basis points on March 1 from 65 on Jan. 2. The five-year spread opened up to 70 basis points from 44 basis points.
To be sure, spreads on the long end have compressed. The spread between the 10-year triple-B taxable MMD yield and the triple-B corporate compressed to 68 basis points from 101 basis points. The spread between the 25-year triple-B taxable MMD yield and the 25-year triple-B corporate yield tightened to 36 basis points from 84 basis points.
While most experts agree taxable munis should be compared to other taxable assets, taxable munis do look attractive relative to tax-exempts. Since the beginning of the year, muni-Treasury ratios have all fallen to a 90% range, and credit spreads have compressed. Also, yields on the triple-A tax-exempt Municipal Market Data scale have fallen on the short end.
The two-year yield fell to 0.31% on March 1 from 0.36% on Jan. 2. The five-year tax-exempt yield fell slightly to 0.76% from 0.84% at the beginning of the year. In comparison, the two-year and five-year triple-A taxable yields have risen over that same time period. The tax-exempt 10-year and 30-year yields have risen, albeit at a much slower pace than their taxable counterparts. The 10-year triple-A tax-exempt yield widened to 1.79% from 1.78%, while the 30-year yield increased to 2.91% from 2.86% at the beginning of the year. Over the same time period, triple-A taxable yields have risen at a much faster pace.
Spreads may have widened so far this year because of an increase in taxable munis. For the first two months of the year, $6.26 billion in taxable bonds were issued, up 56% from the first two months of 2012, when $4.01 billion of taxable bonds came to market. The number of issues was also up to 170 for the first two months of 2013 from 120 issues in 2012. The 56% jump in taxable issuance for the first two months of the year was up dramatically from tax-exempt issuance that was up only 0.9% for the same time period.
Some say the increase in issuance is because taxable munis are more attractive now than they have been in the past.
“There are fewer restraints attached to issuing taxable munis,” Friedland said. “Since the demise of the Build America Bond program, issuers are making more use of taxables now than they have before.”
When Build America Bonds were first issued, Friedland said they made up most of what was trading in the taxable muni market. When the primary market for BABs ended, taxable paper was hard to find. “But now taxable refundings are increasing with hospitals and universities and more issuance is creating more of a market,” he said.
From a buyer’s perspective, taxable munis look attractive. “Muni-to-Treasury ratios are at a point now where a buyer isn’t really giving up that much by buying a taxable muni,” Friedland added. “If your fixed-income portfolio is geared towards corporates, Treasuries or mortgages, taxable munis offer good incremental yield and the opportunity for diversification. The correlation between taxable munis and other taxable assets is relatively low. You can pick up additional yield, not pick up incremental risk, and add diversification to your portfolio.”
Others agree. “We’ve noticed an uptick in taxable issuance,” said Adam Mackey, head of muni fixed income at PNC Capital Advisors. “Clearly there is more demand for taxable munis. Each year, as the calendar rolls, the number of buyers that have entered the market for taxable munis has expanded. Muni issuers potentially get better execution for taxable portions, and it’s a decent form of financing for projects that aren’t eligible for tax-exempt financing.”
Mackey cited three major reasons he has seen an uptick in issuance. “The market has improved in terms of depth and the number of participants that buy taxable munis. Taxable municipal credit spreads have compressed significantly with other spread sectors,” he said. “Also, for the issuer, it’s another source of distribution for them, opening up municipal credit to global investors as opposed to domestic-only investors who benefit from the tax exemption.”
Standard & Poor’s Dow Jones Indexes also tracks taxable bonds and includes new bonds in their indexes. The value of the indexes has risen in recent months as new bonds have come to market, said J.R. Rieger, vice president of fixed-income indices.
As of Feb. 27, the S&P Taxable Municipal Bond Index rose to $312.9 billion and included all new taxable bonds issued in January — up from the $312.3 billion in January. The value is also up from the $307.4 billion included in the index as of September 2012 and $296 billion in the index as of December 2011.
Yields are also higher in the taxable index than in the tax-exempt. As of Feb. 27, the S&P Taxable Municipal Bond Index had a 3.7% yield to worst with a modified duration of 9.2 years, compared to the S&P National AMT-Free Municipal Bond Index with a 1.93% yield to worst with a modified duration of 5.1 years. Accounting for the 35% personal income-tax bracket, the taxable index would have to return 2.97% to retain the same yield after tax.
Comparing the index by duration, the S&P Long Intermediate Term Taxable Municipal Bond Index had a 3.22% yield to worst with a modified duration of 6.9 years. In comparison, the S&P Long Term National AMT-Free Municipal Bond Index had a 3.06% yield to worst with a modified duration of 6.7 years. Taking into account the 35% personal income tax bracket, the taxable index would have to return 4.07% to retain the same yield after tax. And while taxable munis have outperformed recently, some say there are still opportunities.
“Since October, taxable munis have rallied from trading 19 basis points behind long corporates to 16 basis points inside,” Barclays muni researchers wrote. “While taxable munis are trading close to BAB-era and post-BAB-era tights, we believe positive technicals will remain supportive of the sector. Although upside [and] downside is less favorable than in October, we see select opportunities to pick up spread among bonds that trade wide of comparably rated long corporates.”