Prospects for a rise in the corporate tax rate are bringing municipal bonds back into focus for institutional investors. Although widely viewed as an asset class for retail and high-net-worth investors, the reality is that the institutional investor base has grown and now makes up nearly a quarter of the $4 trillion muni bond market. Banks and insurers represent the largest institutional segments.
Instititional investors represent nearly a quarter of the market
As widely expected, President Biden’s proposed American Jobs Plan would raise the corporate tax rate to 28% from 21% to help pay for some $2.25 trillion of new infrastructure development. At a 28% tax rate, tax-exempt muni bond yields would look increasingly attractive relative to corporate bonds, especially in the AA- and A-rated segments, where corporate bond yields are relatively low. Investors seeking higher yields in the corporate market must move down the credit rating scale, increasing the credit risk they must assume to achieve taxable yields that are commensurate with the tax-adjusted yields of munis. Moreover, in the higher rated segments of the market, the opportunity set is much larger in the muni bond market.
Municipals have more weighting than corporates at the highest rated tiers
Relative credit risks are also apparent in comparative default rates. Tax-exempt muni bonds have a lower cumulative default rate across every investment-grade (BBB/Baa and above) rating segment compared to similarly rated corporate bonds.
Municipal bond default rates have remained low
As a portfolio diversifier, tax-exempt muni bonds can help reduce volatility in a fixed income portfolio. Realized volatility over the past five years has been less than that of Treasuries and investment-grade corporate bonds. Much of that mitigation of volatility is due to embedded call options in most muni bonds, whereby duration declines as yields decline (negative convexity). Note this in the below chart that reflects the annualized five-year standard deviation of daily returns.
Historical volatility is relatively lower for municipal bonds
The lower volatility of tax-exempt muni bonds combined with the tax-exempt yield has resulted in strong risk-adjusted results. For institutional investors that focus on steady and strong risk-adjusted returns, muni bonds can make a suitable complement to a broader portfolio. Combined with a higher proportion of higher quality bonds to other high-grade segments of the fixed income market and a tax-exempt income stream, tax-exempt muni bonds are also an attractive opportunity for institutional investors facing potentially higher tax rates.
Muni bonds have shown better risk-adjusted returns, as measured by dividing the return by standard deviation, that are similar to investment-grade (BBB/Baa and above) corporates but higher than Treasuries. Given the different credit profile of muni bonds – representing the credit risk of municipalities vs. corporations – muni bonds can provide diversification and stronger returns in a portfolio.
Stronger results on a risk-adjusted basis for municipals
The bottom line: Formerly an asset class utilized primarily by retail and high-net worth investors, munis are gaining traction from institutional investors. Taking into consideration the competitive returns, relatively low volatility and default track record of muni bonds, historical risk-adjusted returns have been attractive relative to Treasuries and investment-grade corporate bonds. It’s reasonable to expect the share of institutional investors that make up the muni bond market to grow when taking into consideration potentially higher taxes going forward.
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