Taxable Municipal Bonds – A Little-Known Complement for Institutional Investors

November 07, 2022
Taxable municipal bonds offer an excellent way to diversify broader taxable portfolios through high-quality, durable credits that frequently offer higher yields than comparably rated corporate debt.

Bond yields have surged this year as the Federal Reserve (Fed) continues to fight a surge in inflation. Following many years of monetary policy suppression, fixed income valuations have become much more attractive. With all the attention on inflation, Fed tightening, and rising rates, we would like to shine a light on taxable municipal bonds, a growing, and often overlooked sector. Taxable municipal bonds offer an excellent way to diversify broader taxable bond portfolios through high-quality, durable credits1 that frequently offer higher yields than comparably-rated corporate debt. Strong credit resiliency further bolsters the case for taxable municipal debt in the face of ongoing economic uncertainties. BBH portfolios often include allocations to taxable municipal bonds based on their attractive risk-adjusted return benefits and the more efficient portfolio outcomes they help create.

First of All… Taxable Munis?

The Tax Reform Act of 1986 placed a limitation on the purpose type for which municipal bonds could be sold tax-exempt, thus paving the way for federally taxable municipal bonds to emerge. These types of issues generally provide for pension funding, working capital, and refunding of tax-exempt debt. Build America Bonds (BABs), Recovery Zone Economic Development Bonds, and Qualified School Construction Bonds were introduced via the American Recovery and Reinvestment Act of 2009. These types of issues are federally taxable municipal bonds where issuers receive direct payments from the U.S. Treasury to subsidize their interest costs. The Tax Cuts and Jobs Act of 2017 provided another catalyst for taxable issuance by eliminating tax-exempt advance refunding transactions. Even though the overall size of the municipal market has remained steady for the past decade, the taxable portion of it has grown steadily. Currently, taxable bonds comprise 21% of the outstanding municipal market, up from 14% at the end of 2017.

Exhibit I shows that the taxable municipal market has grown to over $800 billion outstanding, and it offers prospective investors a large and deep market to gain meaningful exposures.

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Exhibit I: A bar chart displaying the outstanding debt of the taxable municipal market in billions from 2017 through July 2022, indicating that outstanding debt continues to gradually increase year-over-year.

While the taxable municipal market has grown to a size that can command the attention of institutional investors, it pales in comparison to the size of the corporate bond market as shown in Exhibit II. As we will demonstrate, the municipal market offers persistently higher credit spreads and lower historic default rates than similarly-rated corporate bonds. The taxable municipal market remains capacity constrained with niche opportunities, causing traditional institutional investors to overlook the market for a variety of reasons, including a lack of familiarity, perception of inexperienced issuers, and separation of municipal teams from corporate teams at many firms.

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Exhibit II: A pie chart comparing the size of the taxable municipal market to the much larger corporate bond market, displayed in billions of dollars as of September 30, 2022, with outstanding corporate bonds valued around $10 trillion and taxable municipal bonds valued around $842 billion.

BBH has successfully operated in the taxable and tax-exempt municipal markets for decades by investing the firm’s capital alongside our institutional and private clients. Our municipal team is co-located side by side with other fixed income professionals, allowing us to share a common philosophy, investment approach, and actively collaborate on opportunities. For these reasons, we believe BBH is a compelling partner for institutions seeking to understand the evolution of the taxable municipal market and how it can help improve the outcome of institutional portfolios.

Why Should You Care?

The taxable municipal market has provided higher returns than investment-grade (IG) corporate bonds while exhibiting substantial correlation benefits when paired with corporate bonds. High-grade corporate bond investors should seek allocations to taxable municipal bonds to potentially enhance returns and reduce risk.

Exhibit III shows that taxable municipal bonds have persistently offered higher credit spreads than comparable quality corporate bonds. We attribute this to the difference in relative size between the markets, the erratic historical issuance pattern of taxable municipal bonds, and investors unfamiliarity with the municipal market. While liquidity in the taxable municipal market has improved, it remains well below that of the high-grade corporate bond market. Earning higher yields for accepting lower liquidity is an important part of our investment strategy that requires a long-term orientation.

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Exhibit III: Line graph comparing the option-adjusted credit spread of taxable municipal bonds and corporate bonds rated greater than A3/A, for the timeframe December 2009 through September 2022 displayed in basis points, with taxable municipal bonds regularly greater than that of corporate bonds.

Of the major credit sectors, municipal bonds possess the strongest credit resiliency, which we view as particularly important in today’s environment. Municipal bonds are a major funding vehicle for public policy, and many are backed by revenues from essential services or derived from critical infrastructure. Consequently, the municipal market has a much higher credit quality orientation than corporate bonds. Exhibit IV illustrates how the municipal market contrasts from the high-grade corporate market by credit rating, with the municipal market offering an overall higher average credit quality.

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Exhibit IV: Bar chart comparing the credit rating distribution of taxable municipal bonds and investment-grade corporate bonds as of September 30, 2022, where the taxable municipal bond market offers an overall higher average credit quality, particularly in the Aaa and Aa rating categories.

Municipal bonds have experienced extremely low default rates, and generally demonstrate less volatility than Corporates. As Exhibit V shows, municipal bond defaults have been lower than corporate bond defaults for each respective credit rating category.

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Exhibit V: A bar chart displaying the average 1-year default rates by credit quality for municipals and global corporates, reported from 1970 through 2020, where municipal bond defaults have been lower than corporate bond defaults for each respective credit rating category.

Exhibit VI shows the historical volatility exhibited by intermediate maturity taxable municipal bonds has fallen between the volatility of intermediate maturity Treasuries and intermediate maturity A-rated corporate bonds.

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Exhibit VI: Bar chart displaying the 1-year, 3-year, 5-year, 10-year, and 15-year annualized volatility of treasuries, taxable municipal bonds, and A rated corporate bonds, as of September 30, 2022, where the historical volatility exhibited by intermediate maturity taxable municipal bonds has fallen between the volatility of intermediate maturity Treasuries and intermediate maturity A rated corporate bonds.

We believe the risks to investors are not dissimilar to those of IG corporate bonds, where we have demonstrated that credit spreads persistently offer compensation above and beyond credit losses. Additionally, municipal bond historical losses and volatility have been less than corporate bonds.

The risk-adjusted return benefits of taxable municipal bonds have also produced notable correlation benefits to IG corporate bonds. Exhibit VII shows the historical risk and return characteristics of numerous combinations of taxable municipal and corporate bonds. A 40% allocation to taxable municipal bonds enhanced annual returns by 0.30% per year while simultaneously reducing volatility by 0.40% per year over the past 15 years.

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Exhibit VII: A scatter plot displaying the historical annualized risk and return characteristics of numerous combinations of taxable municipal and corporate bonds, reported for the past 15 years ending September 30, 2022, where the Bloomberg Taxable Municipal Index is greatest in both annualized standard deviation and returns.

Exhibit VIII below contrasts the characteristics of the Bloomberg Taxable Municipal Index, the Bloomberg U.S. Corporate Index, and a 50/50 blend of the two indexes. While the yield on taxable municipal bonds is lower and the duration is higher than corporates, the taxable municipal index has a considerably higher credit quality orientation. The blended portfolio has only moderately longer duration, a higher Sharpe ratio,2 and a much more balanced credit quality composition.

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Exhibit VIII: A table showing the portfolio characteristics, performance, and credit quality distribution of the Bloomberg Taxable Municipal Index, the Bloomberg U.S. Corporate Index, and a 50/50 blend of the two indexes, as of September 30, 2022.

Putting It All Together…

We believe the often overlooked and under-appreciated taxable municipal market warrants the attention of institutional investors. We have shown that taxable municipal bonds can not only potentially enhance returns, but they can also generate diversification benefits to traditional high-grade corporate portfolios. Beyond the benefits provided by the sector, the vastly diverse and fragmented municipal market offers reliable security selection opportunities for bottom-up investors, like BBH. We believe that our active approach that blends a strong valuation framework with credit underwriting that emphasizes durability can unlock the benefits of taxable municipal bonds, just as we have done in traditional tax-exempt bonds for many years.

1 Obligations such as bonds, notes, loans, leases, and other forms of indebtedness, except for cash and cash equivalents, issued by obligors other than the U.S. Government and its agencies, totaled at the level of the ultimate obligor or guarantor of the Obligation. Durable means the ability to withstand a wide variety of economic conditions
2 Sharpe ratio is the return earned in excess of the risk-free rate per unit of return volatility.

Issuers with credit ratings of AA or better are considered to be of high credit quality, with little risk of issuer failure. Issuers with credit ratings of BBB or better are considered to be of good credit quality, with adequate capacity to meet financial commitments. Issuers with credit ratings below BBB are considered speculative in nature and are vulnerable to the possibility of issuer failure or business interruption.

Opinions, forecasts, and discussions about investment strategies represent the author's views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.

Diversification does not eliminate the risk of experiencing investment losses.

Definitions

Bloomberg Taxable Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term taxable bond market. To be included in the index, bonds must be rated investment-grade. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate and must be at least one year from their maturity date.

Bloomberg US Corporate Bond Index represents the corporate bonds in the Bloomberg US Aggregate Bond Index, and are USD denominated, investment-grade fixed-rate, corporate bonds with maturities of 1 year or more.

“Bloomberg®” and the Bloomberg indexes are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Brown Brothers Harriman & Co (BBH). Bloomberg is not affiliated with BBH, and Bloomberg does not approve, endorse, review, or recommend the BBH Structured Fixed Income Strategy. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to the strategy.

The Indexes are not available for direct investment.

Risks

Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.

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