Personalized separately managed accounts (SMA) have evolved into an effective customized solution that seeks to meet a client’s unique financial objectives. Until now, advisors looking for personalized fixed income solutions have needed to factor in key considerations—income requirements, liquidity preferences, investment horizon, credit tolerances and personal values. We believe the focus shouldn’t just be on what you earn, but also on what you keep.
Keeping more of what you earn
Taxes are a crucial element of customization, and when it comes to fixed income investing, every basis point counts. One strategy to potentially enhance after-tax yield and performance involves capitalizing on opportunities across multiple fixed income sectors. With this approach, investors can let their individual tax considerations and relative value in the market select a better after-tax option.
A traditional municipal bond buyer is often an investor in an upper tax bracket, who steers towards tax-exempt municipal bonds as a common fixed income allocation. Why? Because tax-exempt munis are more likely to provide the highest level of after-tax return most of the time. This may not hold true all the time, however.
Using tax optimized ladders
A bond ladder can be constructed with the client’s tax rate in mind. Still within a rules-based portfolio, that traditional muni-only buyer in a mid-tier tax bracket may benefit from a more tactical investing approach.
A tax optimized ladders (TOL) solution aims to optimize the allocation between tax-exempt and taxable bonds based on the client’s tax rate and the relative value between sectors. In short, this method of investing allows an investor to buy the bond with the highest after-tax yield.
We can compare 10-year A+/A/A- rated corporate yields after tax (adjusted for the marginal tax rate of 32%) with 10-year A+/A/A- rated muni yields going back to 2014. When the value is positive (shaded green), corporates provide a higher after-tax yield. When the yield differential falls into negative territory (shaded teal), tax-exempt munis are more attractive.
10-year corporate yield (after tax in 32% bracket) minus 10-year municipal yield
Source: Bloomberg, as of 12/31/2023. Municipal yield is the 10-Year GO BVAL A+/A/A- curve. Corporate yield is the 10-year US Corp A+/A/A- BVAL curve, after tax in the 32% bracket. Difference is computed monthly from December 2014 to December 2023. For illustrative purposes only. Not a recommendation to buy or sell any security.
As expected, tax-exempt munis were more attractive a majority of the time (56% of observations). Interestingly, corporates (after tax) were more attractive 44% of the time, even for an investor in a 32% bracket. In this case, the muni buyer may have benefited by optimizing the allocation of tax-exempt munis and taxable corporates based on relative value.
We offer tax-advantaged core bond market exposure
Municipal bonds are commonly perceived as the default option given their tax exemption, and investors may assume that these investments are the best for them. However, they may fail to consider the change in tax rates that can happen over a portfolio’s life cycle. Many portfolios remain static with those municipal holdings, rather than adjusting future investments with an eye to maximizing after-tax income potential.
Looking at 2021 IRS individual tax filing data, with tax-exempt interest categorized by various tax ranges of adjusted gross income (AGI), we can see an interesting trend. A staggering 60% of those returns came from a tax bracket of 24% or lower!
Percentage of US filers with tax-exempt income by AGI range
Source: IRS.gov, tax filing year 2021, All Returns: Sources of income, adjustments and tax items. In total, roughly 6.6 million of filed returns contained tax-exempt interest.
This finding suggests that a significant portion of municipal bond investors in lower brackets might benefit from a taxable bond allocation. A better outcome could be a tactical investment solution that takes individual tax rates into consideration, while allowing for dynamic allocation between tax-exempt and taxable asset classes.
The bottom line
For clients in the highest tax bracket, tax-exempt municipal bonds have the potential to provide the highest level of after-tax return most of the time, but not all the time. Moving to lower tax brackets, we find that selectively allocating to taxable sectors may become more beneficial. A client’s fixed income allocation can potentially be enhanced to maximize the after-tax income by carefully considering that investor’s tax rate and relative value between sectors.
Parametric and Morgan Stanley do not provide legal, tax or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy.
