US and European regulators provided liquidity that prevented the spread of contagion and a more systemic crisis. That said, while some asset classes were beneficiaries of a flight to quality, others sustained outflows. The bias toward higher quality was illustrated by positive flows for US Treasury exchange traded funds. Conversely, high yield corporate ETFs lost assets.
As so often happens, municipals exhibited more idiosyncratic behavior. Municipals generally exhibit very high credit quality characteristics but are sometimes overlooked when investors flee to safety. Muni ETFs lost assets in the first quarter, which we attribute to the tendency of private households to react to short-term performance results and to the need for liquidity among some investors for tax obligations.
Now that tax season is behind us, the yields on offer should attract more interest. As we describe in our Portfolio Themes section, the taxable equivalent yields for longer-dated AA-rated munis can exceed 7% in states that impose income taxes at high marginal rates. On a risk-adjusted basis, that is arguably superior to other fixed income asset classes. After briefly exhibiting better expected returns across the entire yield curve last month, shorter maturities now appear a bit less attractive. So, we are back to the cross-asset barbell—Treasuries and investment grade corporate bonds on the short end and tax-exempt debt at the longer end.
Portfolio themes
Take note of taxable-equivalent yields (TEYs)
Now that the 18 April tax filing deadline is behind us, we expect tax-free income to prove top of mind for many high-net-worth investors. At present, a 3.5% long-dated tax-exempt municipal bond has a TEY of 5.91%, given a top marginal tax rate of 40.8% (including a 3.8% net investment income tax (NIIT). For investors residing in a state with a high personal income tax rate such as New York, California, or New Jersey, the TEY on long-dated AA munis can exceed 7%.
Construct cross-asset barbell portfolios
Amid continued volatility in the rates market and light supply of short-dated munis, we are now back to recommending cross-asset barbell portfolios for tax-conscious investors. We believe positioning in short-dated taxable bonds in the 1-year to 3-year maturity range (for liquidity and reinvestment opportunities) along with an allocation to longer-dated tax-exempt munis with high coupons (for incremental income) is prudent. As a point of reference, the after-tax yield pickup on AA munis vis-à-vis corporate debt with similar credit ratings in the 13-year to 20-year area ranges from about 26bps to 70bps.
Buy high quality munis
We continue to favor investment grade munis in high quality sectors rather than lower-rated high yield munis in the face of increasing recessionary risks. State governments, electric utilities, and water and sewer debt are among the best examples of sectors that should exhibit credit quality resilience in an uncertain economic environment. By contrast, not-for-profit hospital bonds and the private higher education sector face more challenges from a credit standpoint.
Read the full report Municipal Market Guide: Tax-free income top of mind 18 April 2023.
Main contributor: Kathleen McNamara
This content is a product of the UBS Chief Investment Office.
