Unlocking the Value of Municipal Bond ETFs: A Deep Dive
Municipal bond exchange-traded funds (ETFs) remain an attractive option for investors looking to shelter income from federal—and occasionally state—taxes. With yields that appeal to a wide range of investors, these financial instruments have become more significant in today’s economic climate.
Understanding the Municipal/Treasury Ratio
Renowned muni bond manager John Loffredo, co-head of MacKay Municipal Managers, observes an elevated municipal/Treasury (M/T) ratio, which provides a valuable perspective on municipal bonds’ appeal. This metric compares yield on AAA-rated municipal bonds to U.S. Treasury bonds, revealing the health of the municipal bond market.
Currently, the M/T ratio stands at approximately 75% for 10-year bonds and 91% for 30-year bonds, resulting in yields about 10 basis points higher than usual. Such elevated figures signal that municipal bonds are not just a safe haven in a volatile market—they’re also an enticing prospect for income generation.
The Tax Advantage
When applying tax adjustments, especially at the highest tax bracket of 37%, these yields become exceptionally alluring. For instance, the NYLI MacKay Municipal Intermediate ETF (MMIT) currently boasts a tax-free yield of 3.7%. When factoring in tax implications, this yield translates to an effective yield of about 5.9% for high-income investors. Similarly, the NLYI MacKay Municipal Insured ETF (MMIN) offers a yield of 4%, equivalent to 6.3% after taxes in the same bracket.
This income potential makes municipal bond ETFs particularly attractive for investors seeking tax-equivalent yields that outperform many traditional income-generating investments.
Market Dynamics at Play
Recently, muni bond prices experienced a sharp decline, mirroring trends in other asset classes. Several factors contributed to this downturn, including concerns that Congress might revoke the tax-exempt status of municipal bonds and the current administration’s focus on specific sectors within the muni market, such as private higher education. Investors also faced selling pressure as they sought cash to meet their annual tax obligations.
Despite these challenges, Loffredo remains positive about the outlook for munis. With stable ratings across many states and a more predictable risk profile compared to corporate bonds or other credit markets, municipal bonds are likely to be less volatile if an economic downturn occurs.
Congressional Developments
As Congress works on a tax bill and aims for passage by the July 4 holiday, there is skepticism regarding any changes to the tax-exempt status of munis. Loffredo believes that even if states are pressed to cover more Medicaid expenses, it will not significantly alter their budgets or the outlook for municipal bonds. Many states have developed substantial rainy-day funds, providing a buffer against economic fluctuations.
Furthermore, since states cannot run budget deficits, they have mechanisms in place, such as raising taxes or cutting expenses, to ensure their budgets remain balanced. Remarkably, states like Illinois and New Jersey, often criticized for their large unfunded pension liabilities, are actually showing positive operating balances. Both have made substantial strides in addressing their pension funding timelines.
Conclusion
Investing in municipal bond ETFs offers a unique combination of tax efficiency and relative stability in uncertain markets. As investors explore income-generating options, the insights provided by seasoned professionals like John Loffredo can guide them toward making informed decisions about where to allocate their funds. In a climate where every percentage point counts, municipal bonds deserve a prominent place in the investor’s toolkit.