Key Questions: Why Would Investors Buy into an Overvalued Asset Class?
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Investors are pouring money into municipal bonds even as yields remain low and asset values remain high.
Even though yields on municipal bonds on the front end of the yield curve recently hit historic low levels, investors continue to invest new money into the asset class. In addition, municipals have remained richly priced compared with other fixed income instruments such as corporate bonds and Treasuries for the better part of 2021. As evidence, Lipper reports that fund flows into municipals have been positive for 67 of the past 68 weeks.
At first blush, many would conclude that there are no valid justifications for buying bonds in this environment, but there are some rational explanations. As of September 9, investors sitting in cash waiting for rates to move higher are seeing money market rates of roughly three basis points (0.03%) and T-Bills at six basis points (0.06%). This has led many to view municipal bonds as a short-term alternative, with one-year AAA bonds yielding 0.10%.
When viewing the data above, remember that the income generated from municipal bonds is tax-exempt, so it is essential to calculate the after-tax yield when comparing security types.
Source: Bloomberg LLC, September 9, 2021
While not dramatic in their respective yield differences, a tax-equivalent yield (TEY) for the one-year AAA Municipal increases to 0.15% for investors in a 35% tax bracket and compares more favorably with its taxable peers. That favorable comparison for municipals ends after year one as the yield pickup on an after-tax basis is dramatically better for taxable bonds with a maturity of two years and longer.
Another reason investors reinvest dollars into municipal bonds is because of the strong credit profile compared with their taxable counterparts. The risk of default in highquality municipal bonds is far less than with similarly rated corporates, which resonates with investors’ desire for taxexempt income and safety.
Source: Moody's Investor Service (July 15, 2020) U.S. Municipal Bond Defaults and Recoveries, 1970-2019
These attributes (higher yields and lower risk of default) have even attracted some foreign buyers looking for highquality fixed income assets. According to the Municipal Securities Rulemaking Board (MSRB), foreign ownership of municipal bonds is up 51% from 2010 to $108 billion as of September 2020.
And while that does not significantly influence the nearly $4 trillion asset class, the growing overseas acceptance of municipal bonds is noteworthy.
So, a natural follow-up question as to why investors keep buying municipal bonds is this: Why are investors not selling bonds that are arguably at full value? Over the past few years, the strong performance in municipals has created relatively large unrealized capital gains, some of which include short-term capital gains. Depending upon their tax situations, clients may be reluctant to sell and realize those gains and then move into other asset classes as they wait on clarity from the Biden administration and Congress on future tax rates.
A significant number of municipal retail investors utilize a buy-and-hold strategy when it comes to investing. This makes it less likely for traditional buyers to sell and move between asset classes, which has greatly impacted net fund flow numbers.
Investors in the top tax brackets generally benefit the most from tax-exempt municipal bonds, and it is essential to understand the ever-changing market and adjust as appropriate.
While traditional municipal bond investors enjoy the predictability and safety of the asset class, a buy-and-hold strategy can be an obstacle in maximizing total return in a bond portfolio. Municipal technical conditions often fluctuate: When supply increases or demand wanes, investors must understand the benefit of adjusting the asset mix within a bond portfolio. We continue to analyze the tax consequences and relative value benefits amongst fixed income instruments to determine the most suitable investments for our clients.
For more information, please contact your advisor.