Municipal bonds don’t always have the best after tax returns

April 23, 2012

The following is from guest commentator Terry Hults, Senior Portfolio Manager of Municipal Investments, at AllianceBernstein. It’s helpful to see municipal bond investing in a broader light and the data above really frames the discussion well.

Municipal bonds have an after-tax yield edge over Treasuries, corporates and other taxable bonds most of the time—but not always, as the display above  shows. Opportunities are driven by sector supply and demand, credit-quality trends, volatility, and changes in tax law. Treasuries did best in 2007 and 2008, corporates did best in 2009, and mortgages did best in 2010.

Adding a judicious allocation to these taxable sectors during those years would have meaningfully added to the returns of a tax-aware portfolio. Today, low interest rates and the fear of future rate increases have driven some bond investors into shorter bonds and cash. But an investment strategy that considers municipal and taxable bonds across the full credit spectrum provides greater ability to pursue return without taking undue risk.

It’s true that as the economy improves in the months and years ahead, the impact of rising interest rates will be felt on bond portfolios. But higher-yielding corporate and municipal bonds are much less sensitive to interest rates and typically perform better than lower-yielding municipals (and treasuries) in a rising-rate environment. That’s because their higher yields provide more of a cushion, and the fundamentals of the borrowers tend to improve with the economy. As the economic cycle shifts and rates rise, investing across sectors should help safeguard portfolios.

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