The data shows that taxes play an increasingly important role in customized fixed income investing. Let’s take a look at how.
As investing has grown increasingly personalized, separately managed accounts (SMA) have become a trusted vehicle for customized solutions to meet a client’s unique objectives. Up to now, when looking for personalized fixed income solutions, advisors have considered key factors such as income needs, liquidity requirements, investment horizon, credit tolerances, and personal values. However, it’s not about what you earn; it’s about what you keep.
Keeping more of what’s earned
Taxes are a crucial element of customization, especially in today’s low-rate environment, and every basis point counts. One way to potentially boost after-tax yield and performance is to capitalize on opportunities across multiple fixed income sectors. Doing so lets tax considerations and relative value guide the way.
Taking a traditional municipal bond buyer as an example, for high-net-worth investors in the upper tax brackets, tax-exempt municipal bonds tend to be a common asset allocation. Why? Because tax-exempt munis are likely to provide the highest level of after-tax return a majority of the time. That may not be true all the time, however.
In the chart below, we compare five-year A-/AA-rated muni yields to five-year A-rated corporate yields after tax, with the corporate yields adjusted for the highest marginal tax rate of 37%. The chart shows the muni yield minus the after-tax corporate yield going back to 2010. When the value is positive (shown in green), tax-exempt munis are more attractive. When it falls into negative territory (in blue), the opposite is true; corporates then provide a higher after-tax yield.
As expected, tax-exempt munis were more attractive a majority of the time (65% of observations). Interestingly, corporates (after tax) were more attractive 35% of the time, even for an investor in a 37% bracket. In this case, the muni buyer would have benefited by optimizing the allocation of tax-exempt munis and taxable corporates based on relative value.
Muni yield minus corporate yield after taxes (37% tax bracket)
Source: Bloomberg, as of 6/30/2021. Muni curves are a 50-50 blend of A-rated and AA-rated (MMD); corporate curves are A-rated (Bloomberg BVAL US Corp A).
The same optimization concept applies to after-tax performance rather than just yield. Let’s also assume the muni investor expands their horizon beyond just corporates into US Treasuries, US Agencies, and taxable munis. The table below shows the annual after-tax performance of each sector over the past five years. As you can see, for the investor in a 37% tax bracket, tax-exempt munis led the way only three out of five years. The traditional muni buyer would have benefited from a more tactical approach aimed at optimizing the fixed income allocation based on their tax rate and the relative value between sectors.
Annual after-tax sector performance, 2015–2020
Sources: Corporates: Bloomberg Barclays Corporate Intermediate Index; US Treasuries: Bloomberg Barclays US Treasury Intermediate Index; US Agencies: Bloomberg Barclays US Agency Index; taxable munis: Bloomberg Barclays Taxable Muni Intermediate Index; tax-exempt munis: Bloomberg Barclays 65% Barclays 5-Year Muni Index / Barclays 35% Barclays 10-Year Muni Index. Taxable index income taxed at 37% federal Income tax rate. As of 12/31/2020.
The chart below shows the percentage of tax-exempt dollars received by investors in various ranges of adjusted gross income (AGI). This is IRS data from 2018, the last time they reported this information. As expected, high-net-worth investors in upper brackets with AGI over $500,000 received close to half the tax-exempt dollars. However, 34% of tax-exempt dollars earned came from investors with AGI below $200,000—a tax bracket of 10% to 24%. Again, muni buyers in lower tax brackets may have benefited from some taxable exposure.
Reported receipts of tax-exempt interest, % of interest received
Source: Internal Revenue Service, 2018.
The bottom line
For clients in the highest tax bracket, tax-exempt municipal bonds are likely to provide the highest level of after-tax return most of the time, but not all the time. As you move to lower tax brackets, tactically allocating to taxable sectors may be even more advantageous. There is an opportunity to further optimize a client’s fixed income allocation by carefully considering a client’s tax rate and relative value between sectors.