Muni Yields Look Compelling Relative To Inflation-Indexed Treasuries
The recent rise in muni yields, combined with a decline over the past month in real yields, potentially creates new opportunities for investors looking for tax-advantaged bond holdings.
By James Picerno | The Milwaukee Company | jpicerno@themilwaukeecompany.com
The recent rise in muni yields presents investors with relatively compelling tax-advantaged spreads over real (inflation-adjusted) rates via Treasury Inflation Protected Securities (TIPS). Using a model developed by TMC Research, current muni yields have widened enough over TIPS so that comparing the two on an after-tax basis favors the former. For context, the chart below also shows the market’s implied inflation forecast by maturity, based on nominal Treasury yields less their inflation-indexed counterparts. (Note that some maturities in the chart are based on interpolation using actual yields.)
Consider the 10-year maturity: TradeWeb’s AAA national muni benchmark yield, at 2.94% on Friday, Feb. 21, was roughly a full percentage point above a 10-year TIPS. After factoring in the tax advantages of munis, the benefit may be even wider. (Interest generated by muni bonds is generally exempt from federal income taxes and may also be exempt from state and local taxes.)
History shows that the relative allure of munis vs. real TIPS yields fluctuates. At the moment, munis have a substantial edge, based on TMC Research’s model, which makes several assumptions about the value of tax savings. The two bond types are worth comparing because each offers a unique and investor-friendly benefit that’s unavailable in convention fixed-income securities: sidestepping taxes and hedging inflation.
For TIPS, the opportunity to lock in relatively high real yields can be a powerful advantage, even on an after-tax basis. But because real yields vary through time, so does the degree of the associated benefit. Ditto for the tax savings associated with munis.
Note, however, that munis have an additional advantage: the tax savings are all but certain. By contrast, the inflation-hedging aspect of TIPS is speculative in the sense that future inflation is uncertain. As a result, the opportunity to lock in a real yield at any given point as an inflation-hedging strategy may or may not be advantageous in the future.
To skew the odds in an investor’s favor with TIPS, it helps to buy and hold when real yields are relatively high. Minds will differ on defining “high”, but history suggests that for the 10-year TIPS yield, for instance, levels above 2% are relatively lofty. By that standard, the 10-year TIPS yield – 2.0% as of Friday – is on the borderline.
Meanwhile, a 10-year muni, according to TradeWeb’s benchmark was a full percentage point higher vs. its TIPS counterpart – before factoring in tax advantages. That’s a high bar to beat, especially for investors with high tax brackets and/or living in high-tax states.
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