Do muni bonds really have a higher after-tax yield than lower risk taxable bonds? According to my math, they probably don’t.
Take the iShares National Muni Bond ETF (MUB), the largest municipal bond ETF. While the yield to maturity is 2.85%, much of it is amortization of premium. That’s why Morningstar shows the effective SEC yield for MUB at only 1.62% as of Aug. 13, 2019.
MUB is a solid low-cost intermediate-term ETF with about 22% AAA bonds, but do you really make more after taxes?
To find the answer to that question, I compared MUB’s after-tax returns to two alternative taxable investments. First to the iShares Core U.S. Aggregate Bond ETF (AGG), then to a five-year FDIC insured CD yielding 2.75%. AGG has a pretax SEC yield of 2.38% and has about 72% AAA rated bonds. Durations are similar. Below are the results:
Sizing Up Yield Benefit
Put simply, one would have to be in the 35% tax bracket for MUB to have a greater after-tax yield than AGG. And compared with a 2.75% CD backed by the FDIC with certain limits, MUB trails at any tax bracket. Even at the highest tax bracket, MUB only bests AGG by 0.12% (12 basis points).
Though there are some simplifications in this analysis, they are unlikely to change much.
On the side arguing for munis, those in the highest tax brackets are likely to be subject to the 3.8% net investment income tax that MUB is not subject to. At the highest tax bracket, that would have MUB yielding 0.21% more than AGG, after taxes, but still less than the CD.
On the other hand, AGG is partially state tax exempt (33% in 2018), which, depending on your state, could boost the equivalent after-tax yield on AGG versus MUB. MUB may have some bonds in your state that qualify as state tax exempt, but less than the amount that would be state tax exempt for AGG.
What About Risk?
In spite of a raging bull market, state pensions are still grossly underfunded and have risk. One estimate maintains that only 35% of pension liabilities are funded using realistic assumptions.
I’m certainly not in the camp that believes massive defaults are a given (Meredith Whitney), but I do believe there is risk. If stocks falter, then unfunded liabilities will increase. That could result in systematic defaults and a new correlation to stocks.
Even if your particular situation yields greater income with muni bond funds, is that extra return worth the risk? Buying a lower-credit-quality muni bond fund will surely yield more, but it will also dramatically increase the risk you take. And don’t fall for the muni bond illusion where the broker shows you income that is mostly return of your own principal.
Calculate the extra return (if any) you are getting after taxes by taking on this risk. Though you may think it is worth it, I recommend to my clients that they limit muni bond exposure to no more than 20% of their fixed income.
Never forget that the much better goal is to make more money after taxes than to avoid paying taxes.
Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He has been a nonpaid panelist at one of NGPF's conferences for high-school teachers, but is not part of its organization. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at ar@DareToBeDull.com, or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.