Municipal or Taxable Bonds for High Net Worth Investors?

Perspectives

MAY 2019

Municipal or Taxable Bonds for High Net Worth Investors?

Municipal bonds remain attractive and still make sense for high net worth investors on a go-forward basis even in the wake of the Tax Cuts and Jobs Act that went into effect in 2018 and the spread-widening that we experienced in the credit markets during the fourth quarter of 2018. This research brief compares the current state of municipal bonds versus taxable bonds.

First, a General Rule of Thumb: The Municipal/Treasury Ratio

The key metric that investors use in assessing general attractiveness of municipal bonds versus taxable bonds -- a rule of thumb, if you will -- is called the municipal/ Treasury ratio, shown in Exhibit 1 below. The municipal/Treasury ratio is defined as the Barclays AAA Municipal Bond Index yield-to-worst divided by the 10-year Treasury Bond yield. As it stands today, the municipal/Treasury ratio remains above the longterm average of 0.8, signifying that municipal bond yields are still more attractive than taxable yields for high net worth investors.

Exhibit 1: The Municipal/Treasury Ratio Favors Municipal Bonds 1.6

Benjamin H. Mohr, CFA

Senior Research Analyst, Fixed Income

Aimee O'Connor, CFP?

Senior Vice President

1.4

M/T Ratio

1.2

1.0

0.8

0.6 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Municipal/Treasury Ratio

Average

Note: Municipal/Treasury ratio defined as the Barclays AAA Municipal Bond Index YTW divided by the 10-year Treasury Bond yield Sources: Bloomberg Barclays, Federal Reserve, as of March 31, 2019

CHICAGO BALTIMORE MILWAUKEE PHILADELPHIA ST. LOUIS

Next, a Comparison of Long-Term Historical Returns

Exhibits 2 through 5 below compare the returns of municipal bonds versus taxable bonds, first on a pre-tax basis and then on an after-tax basis. They make the case that in the long-run, municipal bonds consistently provide a superior after-tax return versus taxable bonds on a like-for-like duration basis.

As shown in Exhibit 2, even on a pre-tax basis, over the last 10 years, the Barclays Municipal index has outperformed the Barclays Treasury index handily. Likewise, the Barclays Municipal 1-5 Year index has also outperformed the Barclays Treasury 1-5 Year index over the last 10 years.

Exhibit 2: Trailing Performance, Municipal Bonds vs. Taxable Bonds ? Gross, Pre-Tax 6

5

4

%

3

2

1

0

1Yr

3Yr

BC Treasury 1-5Yr

BC Muni 1-5Yr

Source: Bloomberg as of March 31, 2019

5Yr BC Treasury

10Yr BC Muni

Exhibit 3 below breaks out the individual calendar year performance. One item of note is the noncorrelation between municipal bonds and taxable bonds in the 2008 Housing Crisis and 2009 rebound -- in 2008, as credit spreads widened, Treasury bonds outperformed while municipal bonds lagged. In the 2009 reversal, municipal bonds rallied while Treasury bonds underperformed.

Exhibit 3: Calendar Performance, Municipal Bonds vs. Taxable Bonds ? Gross, Pre-Tax 15

10

%

5

0

-5 2008

Source: Bloomberg

2009 2010 2011 2012 2013

BC Treasury 1-5Yr

BC Muni 1-5Yr

2014 2015 BC Treasury

2016 2017 BC Muni

2018

2

Exhibit 4 below shows that on an after-tax basis, the outperformance of the Barclays Municipal index over the Barclays Treasury index -- as well as that of the Barclays Municipal 1-5 Year index over the Barclays Treasury 1-5 Year index -- is accentuate. The strength of the outperformance of municipal bonds over taxable Treasury bonds is particularly notable over the last 10 years' timeframe.

Exhibit 4: Trailing Performance, Municipal Bonds vs. Taxable Bonds ? Gross, After-Tax 6

5

4

%

3

2

1

0

1Yr

3Yr

5Yr

10Yr

BC Treasury 1-5Yr BC Muni 1-5Yr BC Treasury BC Muni

Assumptions: BC Treasury 1-5Yr and BC Treasury subject to highest 2019 interest income tax of 37% on last 10 years' average 1.8% and 2.6% coupons, respectively. BC Treasury 1-5Yr and BC Treasury also subject to Affordable Care Act's 3.8% net investment income tax. All applied on each annualized return as estimate Source: Bloomberg as of March 31, 2019

Exhibit 5 below is like Exhibit 3 on the previous page, showing calendar performance. The only difference is that Exhibit 5 shows after-tax returns instead of pre-tax returns. As such, the performance of municipal bonds is particularly strong in most years versus taxable bonds.

%

Exhibit 5: Calendar Performance, Municipal Bonds vs. Taxable Bonds ? Gross, After-Tax 15

10

5

0

-5

-10 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 BC Treasury 1-5Yr BC Muni 1-5Yr BC Treasury BC Muni

Assumptions: BC Treasury 1-5Yr and BC Treasury subject to highest 2019 interest income tax of 37% on last 10 years' average 1.8% and 2.6% coupons, respectively. BC Treasury 1-5Yr and BC Treasury also subject to Affordable Care Act's 3.8% net investment income tax Source: Bloomberg

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Finally, we examine Tax-Equivalent Yields

The stronger performance of municipal bonds over taxable bonds as shown previously comes from the consistently superior tax-equivalent yields of municipal bonds versus taxable bonds, as shown in Exhibit 6 below. Over the last three years, the Barclays Municipal tax-equivalent yield-to-worst has been stronger than the Barclays Treasury yield-to-worst. Likewise, the Barclays Municipal 1-5 Year tax-equivalent yield-to-worst has been stronger than the Barclays Treasury 1-5 Year yield-to-worst.

Exhibit 6: Municipal Bonds Provide Better Tax-Equivalent Yield than Taxable Bonds 6 5 4 3 2 1 0

%

Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Ap r- 17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Ap r- 18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 Feb-19 Mar-19

BC Treasury 1-5Yr YTW BC Treasury YTW

BC Muni 1-5Yr YTW BC Muni YTW

BC Muni 1-5Yr Tax-Equiv YTW BC Muni Tax-Equiv YTW

Source: Bloomberg as of March 31, 2019, assumes highest 2019 tax bracket of 37% and Affordable Care Act's 3.8% net investment income tax applied on yields at every period; yield available for BC Muni 1-5Yr only since September 2016

Similar to Exhibit 6 above, Exhibit 7 below shows that the municipal high yield tax-equivalent yield-to-worst has been consistently better than corporate high yield yield-to-worst.

Exhibit 7: HY Municipal Bonds Provide Better Tax-Equivalent Yield than HY Corporate Bonds 25

20

15

%

10

5

0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

BC Agg YTW BC HY YTW

BC Muni YTW BC Muni HY YTW

BC Muni Tax-Equiv YTW BC Muni HY Tax-Equiv YTW

Source: Bloomberg as of March 31, 2019, assumes highest 2019 tax bracket of 37% and Affordable Care Act's 3.8% net investment income tax applied on yields at every period

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Conclusion

In conclusion, we have seen through this research brief that the municipal/Treasury ratio currently still favors municipal bonds, that municipal bond performance on a long-term and after-tax basis is consistently stronger than that of its taxable counterparts, and that this outperformance is driven by consistently superior taxequivalent yield from municipal bonds over taxable bonds. Marquette would recommend that high net worth investors and family offices continue to consider municipal bonds in their various forms -- from short duration municipal bonds to intermediate/core municipal bonds to high yield municipal bonds -- as they provide stronger tax-equivalent yields and after-tax total returns over their taxable counterparts.

PREPARED BY MARQUETTE ASSOCIATES

180 North LaSalle St, Ste 3500, Chicago, Illinois 60601 CHICAGO BALTIMORE MILWAUKEE PHILADELPHIA ST. LOUIS

PHONE 312-527-5500 WEB

The sources of information used in this report are believed to be reliable. Marquette Associates, Inc. has not independently verified all of the information and its accuracy cannot be guaranteed. Opinions, estimates, projections and comments on financial market trends constitute our judgment and are subject to change without notice. References to specific securities are for illustrative purposes only and do not constitute recommendations. Past performance does not guarantee future results.

Marquette is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Marquette including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.

About Marquette Associates Marquette Associates is an independent investment consulting firm that guides institutional investment programs with a focused client service approach and careful research. Marquette has served a single mission since 1986 ? enable institutions to become more effective investment stewards. Marquette is a completely independent and 100% employee-owned consultancy founded with the sole purpose of advising institutions. For more information, please visit .

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