Should I Invest in Municipal Bonds?

Municipal bonds are attractive after-tax investments for those in higher tax brackets and do a better job
of diversifying stock risk than corporate bonds. National Muni Bond ETFs provide a low-cost and simple
way to invest in a broadly diversified portfolio of municipal bonds. However, closed-end municipal bond
funds are sometimes a more attractive way to invest in the space when they are trading at an unusually
large discount to the net asset values of their portfolios.

The Primary Reason to Invest in Muni Bonds: Tax-Free Income

To determine if municipal bonds might be an attractive

investment for you, the first step is to estimate your marginal For those in the top three brackets,
tax rate (MTR). This is the rate that you will pay on the last or chances are that some allocation to
“marginal” dollar of income (not your overall average tax rate). municipal bonds will make sense.
The table below is provided by the Tax Foundation:

Tax Brackets and Rates, 2019

Rate Unmarried Individuals Married Filing Jointly Heads of Household
10% $0 $0 $0
12% $9,700 $19,400 $13,850
22% $39,475 $78,950 $52,850
24% $84,200 $168,400 $84,200
32% $160,725 $321,450 $160,700
35% $204,100 $408,200 $204,100
37% $510,300 $612,350 $510,300

For those whose income puts them in the top three brackets, chances are that some allocation to
municipal bonds will make sense because they avoid federal taxation. Note that the table above applies
only to federal income taxes. Most states also tax bond interest income. However, most states do not
tax interest on municipal bonds issued by municipalities within their own state, including bonds issued
by the state itself. Investors in states with high tax rates, such as California, New Jersey, and New York,
often find it most attractive to invest in municipal bonds or bond funds that focus on their state. This
article focuses on national municipal bond funds. However, if you are in a high-tax state, you may find
that investing in a fund focused on your state will be more attractive.

1
Yield Comparisons

The graph below is an “apples to apples” comparison of after-tax

Muni bonds usually have higher
yields between municipal, corporate, and Treasury bonds. A 35%
after-tax yields than comparable
tax is applied to Treasury and corporate bonds. A marginal tax
Treasury and corporate bonds.
rate (MTR) of 35% is the mid-point within the highest three
federal tax brackets.

After-Tax Yield @ 35% Marginal Tax Rate

6

5
Muni Bonds have
higher after-tax yields
4

3
%

0
2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019
3-10Y Treasuries Natl Muni Bonds 5-10Y AA Corporates

2
Risk Comparisons

Two kinds of risk matter most for bonds: credit risk and interest rate risk. Treasury bonds have no
credit risk. Defaults of municipal bonds are very rare. A Moody’s study of municipal bond defaults over
the last 42 years revealed that only .8% of investment grade bonds defaulted within 10 years of
issuance. Commenting on that study, Nuveen says “The 10-year average cumulative default rate for
investment grade municipal bonds through 2017 totaled only 1.23%, compared to corporate bonds at
7.10%. AAA corporate bonds defaulted at a similar rate to BBB municipal debt, at 0.81% and 1.15%,
respectively.”

With credit risk so low for investment grade muni bonds, the most relevant risk is interest rate risk, as
measured by duration, which calibrates the sensitivity of bond prices to changes in interest rates. In the
last few years, the duration of muni bonds has been less than that of comparable corporate bonds.

Weighted Average Duration

9.0

8.5

8.0

7.5

7.0

6.5

6.0

5.5

5.0

4.5

4.0
2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

3-10Y Treasuries Natl Muni Bonds 5-10Y AA Corporates

3
Correlation Comparisons

The primary risk in nearly all portfolios is stock market risk.

That is the risk that needs to be diversified with bonds. The
Municipal bonds usually have a lower
way to statistically measure the diversification benefit of an
correlation with stocks than corporate
investment is its correlation with the stock market—the
bonds, better diversifying stock risk.
lower the better. Municipal bonds usually have a lower
correlation with stocks than corporate bonds, so they do a
better job of diversifying stock market risk, though not quite
as low as Treasury bonds.

Rolling 36-Month Correlations with S&P 500

0.80

0.60

0.40

0.20

0.00

-0.20

-0.40

-0.60

-0.80
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

3-10Y Treasuries Municipal Bonds 5-10Y AA Corporates

4
A Good Way to Invest in National Munis: ETFs

There are two very large and liquid low-cost national municipal bond exchange-traded funds (ETFs) that
are quite popular with investors: iShares National Muni Bond ETF (MUB) and Vanguard Tax-Exempt
Bond ETF (VTEB). We consider them the most attractive default national muni bond funds because of
their very low expense ratios (.07% and .08%, respectively) and tight bid-ask spreads. Both are
passively-managed index funds based on the same benchmark index: S&P National AMT-Free Municipal
Bond Index. Consequently, their characteristics and holdings are highly similar and representative of the
entire municipal bond market. To represent the short end of the muni market, we use iShares iBonds
Sep 2020 Term Muni Bond ETF (IBMI), which tracks a market-value-weighted index of investment-grade
AMT-Free municipal bonds that mature between June and August of 2020.

As shown in the graph below, an investor with a 35% MTR will find that any combination of IBMI and
VTEB or MUB will, from a yield/risk standpoint, dominate Treasury ETFs. Because of their low expense
ratios and bid-ask spreads, we use Schwab Short-Term US Treasury ETF (SCHO) and Schwab
Intermediate-Term US Treasury ETF (SCHR) to represent the Treasury market.

The municipal bond yield curve, unlike the Treasury yield curve,
still has a very positive slope. This means that investors are Investors are rewarded for taking
rewarded for taking on incremental interest rate risk in the muni on incremental interest rate risk
bond market. in the muni bond market.

Yield/Risk Comparisons
Treasury and Muni Bond ETFs
As of May 31, 2019
3.0

VTEB/
After-Tax Yield @ MTR of 35%

2.5
Muni MUB
2.0

1.5 IBMI Treasury

1.0 SCHO SCHR

0.5

0.0
0.0 1.0 2.0 3.0 4.0 5.0 6.0
Duration (Int. Rate Risk)

5
A Better Way to Invest in Munis: Closed-End Funds

Another way to invest in municipal bonds is through a

muni bond closed-end fund. Closed-end funds (CEFs) are At Sapient Investments, our investment
mutual funds that have a fixed number of shares and universe includes not only nearly 500
trade during the day on exchanges like stocks. They ETFs, but also over 500 closed-end funds.
differ from open-end mutual funds that are bought and
sold in direct transactions with the fund company at the
fund’s net asset value (NAV)—the value of the underlying portfolio. In this respect, they are similar to
ETFs. However, because ETFs can easily increase or decrease shares outstanding, ETFs trade at prices
very close to NAV. Closed-end funds often trade at prices that differ from NAV by a substantial
amount—usually at a discount. These persistent discounts are a puzzling anomaly and sometimes
provide very attractive investment opportunities.

At Sapient Investments, our investment universe includes not only nearly 500 ETFs, but also over 500
closed-end funds—every CEF that trades in the U.S. Our quantitative research has found that CEF NAV
discounts are extremely strong indicators of value. Unusually large NAV discounts usually revert back
towards their historical average, providing an important boost to return. In fact, we have found that the
NAV discounts of closed-end funds is the single most powerful and persistent investment anomaly
available to investors today.

In addition to trading at prices that may differ from NAV, closed-end funds also differ from open-end
funds and ETFs in that closed-end funds may utilize a limited amount of leverage. Structural leverage
increases the amount of assets owned by the fund. For example, a $100 investment in a closed-end
fund with 40% structural leverage will have a portfolio of $140 in assets and $40 in debt. The average
amount of leverage among closed-end funds utilizing structural leverage is 26%.

Because closed-end funds can borrow at much lower interest rates than individuals, owning closed-end
funds is an economically attractive way for individual investors to obtain leverage. As long as the rate
paid on the debt is lower than the return on the assets purchased with the debt, the fund will enhance
its return with leverage. If the opposite is the case, the fund will magnify its losses. The use of debt
increases the risk of a closed-end fund, but in a controlled and rational way. About two-thirds of closed
end funds utilize some form of debt. At Sapient Investments, we consider a reasonable level of cheap
leverage to be one of the most attractive features of closed-end funds. Nearly all financial companies
utilize leverage at much higher levels. Much of Warren Buffett’s long-term alpha can be explained by
Berkshire Hathaway’s use of cheap leverage at an average level of 1.6 to 1, according to one well-known
study.

Perhaps because of their largely retail ownership, CEFs are mostly bought on the basis of their
distribution yield. Other considerations, such as their level of interest rate risk (duration) are often
poorly understood. If a higher yield can be obtained by
going out further on the maturity spectrum, CEF
managements know that most of their investors will We consider a reasonable level of
approve. As shown below, the median yield for national cheap leverage to be one of the most
muni CEFs is decidedly higher than for the overall muni attractive features of closed-end funds.
market as represented by VTEB/MUB, but interest rate risk
is also higher.

6
 Yield/Risk Comparisons
ETF and CEF National Muni Bond Funds
As of May 31, 2019
5.3

4.8
Median
4.3
Nat'l CEF
3.8
VTEB/
Yield %

3.3
MUB
2.8
(ETFs)
2.3

1.8
IBMI
1.3

0.8
0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0
Duration (Int. Rate Risk)

At Sapient Investments, what attracts us to municipal bond CEFs is not their higher yield/duration
tradeoff. Rather, our interest in them lies with their relatively inefficient pricing. For those with the
data, the know-how, and the motivation to dig deeper, inefficiency means opportunity.

For example, although CEFs usually trade at a discount to their NAVs, the level of the discount varies
widely over time and across CEFs. Our research shows that there are strong mean-reverting tendencies
in NAV discounts. That is, they tend to revert back towards their average levels if they get too away.
Keeping track of the NAV discounts provides an opportunity to add considerably to prospective return.
In fact, our research indicates that the NAV discount factor is the single most powerful ETF or CEF
selection factor in our arsenal.

Check back with us for updated information regarding which closed-end muni funds we are currently
finding to be most attractive. The dynamics of the
CEF market are constantly changing, but it is highly
likely that we are finding some attractive values in The NAV discounts of closed-end funds is the
muni CEFs that cause us to prefer them over muni single most powerful and persistent investment
anomaly available to investors today.
ETFs or mutual funds. Also, depending upon your
state, it may be even better to invest in a state-
specific muni fund. We can provide you with
detailed analysis and recommendations.