David Blair, a veteran bond-portfolio manager with First Eagle Investments, sees 'incredible value' in the tax-exempt municipal space right now

Yields on municipal bonds - adjusted for taxable-equivalent comparisons - have widened dramatically over those of corporate bonds over the past two months.

This is a very good moment for you to look into tax-exempt bonds if you are investing for income.

The relationship between yields on municipal bonds and fully taxable bonds is dynamic. The scene is completely different from what it was only two months ago, and the good times may last for a little while longer, perhaps through November.

David Blair, a bond-portfolio manager at First Eagle Investments in New York with experience in leadership roles at Nuveen and Pimco, called the increase in yields for tax-exempt municipal bonds "one of the bigger moves in the market we have seen over the past decade."

To illustrate this point, we can compare the yields of two investment-grade bond indexes.

The Bloomberg Municipal Bond Index has a yield to worst of 4.40%, while the Bloomberg U.S. Aggregate Index of corporate bonds has a yield to worst of 5.28%. Bond yields reflect the current market prices of what the capital gains or losses will be when the bonds are redeemed at face value. "Yield to worst" refers to the lower of two things: the yield to maturity and the yield to call. Definitions of bond terms are further down in this article.

Since the bonds in the Bloomberg Municipal Bond Index pay interest that is exempt from federal income taxes, we need to do a simple calculation to compare the yields of the two indexes.

For the first example, we will use the 24% federal income-tax rate, which applies to individuals with annual taxable income from $105,701 to $201,775 and to married couples filing jointly with income ranging from $211,401 to $403,550.

If we divide the 4.40% tax-exempt yield by 0.76 (1 minus 0.24), we have a taxable-equivalent yield of 5.79%, which is 51 basis points (0.51 percentage points) higher than the taxable yield of 5.28%.

If we had done the same calculation with the two bond indexes' yields on July 13, the comparison would have been unfavorable for tax-exempt bonds. On that day, the Bloomberg Municipal Bond Index had a yield to worst of 3.67%, for a taxable-equivalent yield (based on the 24% federal bracket) of 4.83%. That was 8 basis points lower than the yield of 4.91% for the Bloomberg U.S. Aggregate Index that day.

It turns out that the taxable-equivalent spread for these two indexes hasn't been this wide in over a year. And the negative spread of 8 basis points on July 13 was the worst taxable-equivalent spread over the past year.

Keep in mind that this example was confined to investment-grade bonds, which are those rated BBB- or higher by S&P Global, or Baa3 or higher by Moody's Ratings. You can review S&P's ratings hierarchy here and Moody's rating scale here.

You don't need to take much credit risk

Blair is part of a team at First Eagle led by John Miller that manages several municipal bond funds. He and Miller manage the First Eagle Core Plus Municipal Bond Fund, which was launched in November, and the First Eagle Core Plus Municipal exchange-traded fund FECM, which was launched in June. Those funds are focused mainly on investment-grade bonds but also hold some high-yield bonds.

Miller manages the First Eagle High Yield Municipal Fund FEHIX and the First Eagle High Yield Short Duration Fund FDUIX, both of which mainly hold bonds with ratings below investment grade or with no ratings at all.

Getting back to our example of the Bloomberg Municipal Bond Index, those bonds have an average maturity of 13.3 years, but many (or most) have call dates after which the issuer can redeem the bonds early, at face value. This gives the index an effective duration (defined below) of seven years, which lowers price volatility. According to Blair, a maturity range of 10 to 15 years is ideal for bonds being issued now.

"We are at absolute yield levels we have not seen in 20 to 25 years," he said about the tax-exempt market. Right now, 10-year AAA-rated municipal bonds have yields at about 75% of the yields on U.S. Treasury notes BX:TMUBMUSD10Y, while 30-year AAA municipal bonds have yields at about 91% of the yields on 30-year U.S. Treasury bonds BX:TMUBMUSD30Y, he added.

"It has become a buyer's market, and I expect it to continue to be the case [for municipal bonds] through October and November," Blair said. "Seasonally, there is less cash coming into the market from bonds maturing, but supply is pretty robust."

He provided two examples of municipal bonds rated AAA by S&P, Moody's and Fitch Ratings, and here we will show the taxable-equivalent yields for five federal income-tax brackets. You can look up your own marginal tax rate as compiled by NerdWallet, based on the Internal Revenue Service's revision to the tax-bracket ranges published last October. All terms are defined in the last section of this article.

Here is basic information about the two bonds:

 
Cusip No.                                  Issuer                             Coupon Maturity  Call date   Sept. 21 price  Yield to worst 
575829PV2                                  Massachusetts Clean Water Trust     5.00%  2/1/41    2/1/36            105.648           4.26% 
373385PS6                                  State of Georgia                    5.00%  7/1/41    7/1/36            105.932           4.25% 
                                                                                                Sources: First Eagle Investments, FactSet 

And now we have the taxable-equivalent yields, based on the bonds' yields to worst and five federal tax brackets:

 
Issuer                                       Yield to worst  TEC at 22%  TEC at 24%  TEC at 32%  TEC at 35%  TEC at 37% 
Massachusetts Clean Water Trust                       4.26%       5.46%       5.61%       6.26%       6.55%       6.76% 
State of Georgia                                      4.25%       5.45%       5.59%       6.25%       6.54%       6.75% 
                                                                              Sources: First Eagle Investments, FactSet 

You might be well-served by adding credit risk

While he provided two examples of municipal bonds with the lowest credit risk, Blair said that adding exposure to high-yield bonds has been a good strategy for long-term investors. The First Eagle Core Plus Municipal Bond Fund can have up to 30% of its portfolio in high-yield bonds, while the First Eagle Core Plus Municipal ETF can have high-yield exposure of up to 15%.

For 10 years through Monday, the Bloomberg Municipal Bond Index returned 19% with interest payments reinvested, while the Bloomberg Municipal Bond High Yield Index returned 41.4%, according to FactSet. That return shows that the higher interest payments have outweighed the greater volatility and higher rates of bond defaults and credit losses for the high-yield index.

Bond terminology

Here are definitions for some of terms used above.

Tax treatment: U.S. Treasury securities pay interest that is exempt from state and local income taxes. Most municipal bonds (those issued by U.S. states or smaller government units within them) pay interest that is exempt from federal income taxes. A municipal bond issued within the state where you reside will pay interest that is also exempt from your state's income taxes. Tax-exempt munis issued within New York City pay interest that is exempt from federal, state and city income taxes.

Maturity date and call date: This is when a bond will be repaid at face value. Municipal and corporate bonds also typically feature call dates. The issuer may call the bond (redeem it, typically at face value) on or after the call date.

Price: This is a bond's price relative to its face value. If a bond is trading at its face value, we say it is trading at 100, or at par. If it is trading at 1% above or below its face value, we say it is trading at 101 or 99, respectively.

Coupon: The interest rate that a bond issuer pays based on the bond's face value.

Yield: The expected rate of return on a bond, expressed as a percentage. The current yield is a bond's coupon rate divided by its price. A bond trading at a discount to par will have a current yield higher than the coupon. A bond trading at a premium to par will have a current yield below the coupon.

Yield to maturity: An annualized figure that factors in the current market price, the coupon and the capital gain or loss if you hold the bond until maturity.

Yield to call: This is similar to the yield to maturity, except that it incorporates the call date rather than the maturity date.

Yield to worst: The lower of the yield to maturity and the yield to call. Typically, this will be the only market-price-based yield figure available when selecting bonds through a brokerage account, which helps simplify comparisons.

Duration: A measure of volatility for bond portfolios, expressed as a number of years. A duration of 6 indicates that if interest rates rise by 1%, the bond portfolio's market value will decline by about 6%, and vice versa.

Cusip: A unique identifying number used to identify a security or fund in the U.S. and Canada.

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