Taxable US investors usually invest the fixed-income part of their portfolios in municipal bonds. But a tax-aware strategy with the flexibility to look for the highest after-tax return across sectors is likely to be more rewarding over time, as my colleague Terry Hults explains below.
What’s Best After Taxes?
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 below 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.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Douglas J. Peebles is Head of Fixed Income and Terry Hults is a Senior Portfolio Manager, Municipal Investments, both at AllianceBernstein.