Supply and Demand: Cross-Over Investments for Tax-Efficient Investors
Improved fundamentals and diminished supply in the municipal market have created an environment where taxable bonds may offer value to tax paying investors even on an after-tax basis. This commentary discusses opportunities to enhance the after-tax yield and total return of a bond portfolio by using Treasuries, corporates and mortgage-backed securities.
- For more than three years, the municipal bond market has been shrinking as municipal issuers across the country have embraced fiscal conservatism.
- Demand for municipal bonds has been growing and investors have poured billions of dollars into the market in search of tax-efficient interest income throughout 2014.
- As the relationship between the municipal and Treasury markets is not immune to the law of supply and demand, parts of the municipal market have now richened in value versus Treasuries to levels that are statistically overvalued, particularly highly rated shorter maturities.
- Our after-tax total return analysis highlights that taxable bonds are more attractive than municipals in shorter maturities. Treasuries offer the additional benefit of providing investors with sector diversification as well as a safe haven hedge against a proliferation of geopolitical risks.
- Bond value can be determined by comparing potential after-tax returns over a longer time horizon. This allows us to observe the contribution from not only yield, but also “roll-down” return, which is the incremental price appreciation that occurs in a bond as it ages down a steep yield curve.
- Taxable curves are currently steeper than municipal curves in the shorter maturities. Therefore, shorter taxables can offer greater roll-down return than comparable maturity municipals.
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