The timeliness of a tax-aware crossover strategy

Tax-exempt bonds have finally become compelling again. Municipal bonds (munis), which enjoyed a great year in 2021, have underperformed since the start of 2022. Investors who hold munis may have been shocked to learn from their first quarter statement that municipal returns were down across the curve. Typically, investors hold munis for capital preservation and this year munis have not delivered. Muni valuations have come off of the extremely expensive levels we saw in 2021 and we believe there is now an opportunity to begin scaling into the trade. While it is still early to go “all in” on munis, as crossover investors evaluating the universe of tax-exempt versus taxable bonds, we are well positioned to make this rotation.   

The municipal environment this year conjures memories of the 2013 Taper Tantrum, when rates rose quickly, and retail investors shifted money from munis to cash. The backdrop is also quite comparable as we believe the story today is a technical one, not a fundamental one. From a fundamental standpoint, municipal issuers are flush with cash. They received $1.6 trillion in Covid stimulus money and best estimates are that they have only spent half of the proceeds. Broadly speaking, municipal credit is strong, and we are confident in the sector’s fundamentals.  

Technical conditions are a story of supply and demand and can reverse quite quickly. Roughly $100 billion of inflows in 2021 led to one of the most expensive tax-exempt muni markets we have seen in quite some time. That flip switched and year-to-date in 2022, the municipal market has seen $55 billion of outflows driven by a fear of rising rates. These outflows, and the subsequent drop in valuations as supply exceeds demand, have led to the downturn in performance.  

As crossover investors we seek to identify the best opportunities in the fixed income universe on an after-tax basis and, for high-net-worth investors, that typically entails tax-exempt munis. Starting points matter, however, and we have the flexibility to rotate out of munis when they become expensive and back into the sector when valuations become more attractive. Our proprietary measure (the Net Implied Tax rate or NIT) is used to gauge relative value between tax-exempt municipals and similarly rated corporates. Figure 1 illustrates how unusual the market was in 2021 as well as where we are today. In our 30+ years of observing the NIT, munis were more expensive relative to similarly rated corporates only 2% of the time. This signal, in combination with low muni/Treasury ratios, indicated that munis were expensive.

The advantage of a crossover strategy is we could take our muni allocation down last May to our lowest level historically (close to 50%) at a time when municipal valuations rose, and our signals screamed that munis were expensive. During that time, we sold munis and allocated to corporate bonds, where we saw better opportunities on an after-tax basis. Now the opposite is true, and we have been selling those corporate bonds to buy munis.   

We believe the best value in the tax-exempt market now is bonds referred to as “de minimis” bonds. These are bonds with low coupons that were issued when rates were extremely low in 2020 and 2021 and that are now trading at deep discounts. Per IRS rules, a portion of the discount is taxable. Large institutional buyers, such as banks and insurance companies, see value in these bonds and are selectively buying them. This trade is not only for large institutions, however. As after-tax total return buyers, we also can take advantage of the value in our Tax Aware funds. In some instances, we are buying bonds with eye-popping after-tax yields of 4.2%. 

Concerns about inflation, the speed of the Fed’s rate hiking cycle and looming fears of recession will continue to drive municipal valuations. This means we will prudently scale into the muni trade. We also believe that Agency MBS may be an opportunity later this year as the Fed is about to embark on the reduction of its $9 trillion portfolio by selling securities that will include $35 billion of agency MBS per month.  

We believe most investors want to have more money left after they pay taxes; not simply minimize the amount of taxes they pay. Minding that objective, we will continue to seek to invest in the best sectors on an after-tax basis by capitalizing on opportunities as they arise. Today that means we are muni buyers.