Municipal bonds (or munis) have long anchored fixed income allocations for U.S. taxable investors. For investors in higher tax brackets, they are often used as part of portfolio planning and may offer potential after‑tax income benefits across market cycles.
These tax-efficient bonds don’t often grab headlines, yet some recent developments might make them a compelling investment choice: Evolving tax policies, particularly in high‑tax states, can make their after-tax yields more appealing, while elevated issuance by cities and states would provide more opportunities to buy these bonds when yields are higher.
We’ll discuss what these securities can add to your portfolio.
The base case: Why tax-efficient income matters
Income from municipal bonds isn’t subject to federal income taxes, and in many cases, it isn’t subject to state income taxes either. This means it can provide tax‑efficient yields for investors while financing essential infrastructure such as schools, transportation, hospitals and utilities.
Muni bonds typically have lower nominal or pretax yields when compared to riskier high yielding non-municipal bonds, which masks their appeal: From an investor’s standpoint, after‑tax yields matter most, which means munis continue to look compelling for tax-paying investors.
Today, if you are an investor in a top tax bracket (and depending on state and local tax rates), a 4% tax-free municipal bond yield can deliver the same amount of income as a taxable bond that yields approximately 6.75%. This can make a significant difference for you as a high income investor.
What’s changing?
State taxes further widen the gap between pre‑ and after‑tax bond returns. California and New York have top marginal rates above 10%, amplifying the tax burden for residents. New York, Virginia, Rhode Island and Michigan have all increased taxes, and Washington passed legislation to impose a personal income tax on high earners. We believe this trend will continue.
This makes municipal bonds more attractive. Interest on these bonds remains exempt from federal income tax, and unlike most other investment income, it is also exempt from the 3.8% Medicare surtax on net investment income (or NIIT)1 .Furthermore, if you purchase bonds that are issued by the state you reside in, in most cases you do not have to pay state and local taxes on that income.
The taxable-equivalent yield (TEY) framework illustrates the tax advantages of muni bonds. It compares taxable bonds to tax-free municipal bond, showing how much additional nominal yield an investor would need to match the after-tax income a muni bond can potentially deliver.2 This table shows the results are striking: