Wealth explained
A municipal bond yield means nothing until the buyer supplies their own tax rate
The same bond is cheap for one household and expensive for another, and the gap between them is wider than any plausible view on interest rates. Taxable equivalent yield is the only number worth comparing.
In this story
Illustrative. Bank Season is an editorial prototype. This story, its sources, the issuers named in it and every figure it quotes are invented to demonstrate the publication. Nothing here is reported fact or investment advice. Read the disclosure.
A municipal bond is the only fixed income instrument whose yield is incomplete as printed. A Treasury quoted at 4.18% pays 4.18% to everyone. A municipal bond quoted at 3.55% pays 3.55% to a buyer in a low bracket and the equivalent of six percent to a buyer in a high one, and the broker who shows both of them the same screen is not being unhelpful. The tax rate is the buyer's private information, and until it is supplied the quote cannot be compared with anything.
The only comparison that means anything
Taxable equivalent yield divides the tax free coupon by one minus the buyer's marginal rate. The arithmetic is trivial and the discipline of doing it is where the value sits, because the answer moves so far across the bracket table that two households can look at one bond and reach opposite and equally correct conclusions.
Taxable equivalent yield on a 3.55% ten year general obligation bond
| Buyer's marginal position | Surtax applies | Stated yield | Taxable equivalent yield | Spread over the 10 year Treasury |
|---|---|---|---|---|
| 22% federal | No | 3.55% | 4.55% | plus 37bp |
| 24% federal | No | 3.55% | 4.67% | plus 49bp |
| 32% federal | No | 3.55% | 5.22% | plus 104bp |
| 35% federal plus surtax | Yes | 3.55% | 5.80% | plus 162bp |
| 37% federal plus surtax | Yes | 3.55% | 6.00% | plus 182bp |
| 37%, surtax and 5% state, in-state bond | Yes | 3.55% | 6.55% | plus 237bp |
Assumes a 10 year Treasury yield of 4.18% and the 3.8% net investment income surtax where applicable. State treatment assumes full exemption of in-state issues, which is the rule in most but not all states.
Read the first and last rows together. The bond yields 37 basis points more than a Treasury for one household and 237 basis points more for another. A buyer in the 22% bracket who holds municipals in a taxable account is accepting the credit risk of a local issuer and the liquidity of a market that trades by appointment in order to earn a third of a percentage point. That is not a portfolio decision, it is an oversight, and it is extremely common in accounts that were set up decades ago and never reviewed after a change in circumstances.
133bp
Difference in taxable equivalent yield on one bond between the 24% and 37% federal brackets
4.67% against 6.00%, before any state exemption. The bond, the issuer and the maturity are identical in both cases.
Four rules that change the answer
The bracket calculation gets a buyer most of the way. Four specific provisions account for nearly all of the remaining distance between the number on the screen and the money that arrives.
- The de minimis rule. A bond bought at a discount greater than a quarter of a point per year remaining to maturity has its accretion taxed as ordinary income rather than as capital gain, which can turn an apparently cheap secondary market bond into the most expensive line in a portfolio.
- Private activity bonds. Issues financing airports, stadiums and certain housing projects are exempt from regular federal tax but included in the alternative minimum tax base, so a buyer exposed to that regime should treat the quoted yield as optimistic by 30 to 60 basis points.
- State exemption and the concentration it buys. In-state bonds escape state tax, which is worth real money in high tax states, and the cost of collecting it is a portfolio concentrated in one issuer's economy and one legislature's decisions.
- Call features. Most municipal bonds are callable roughly ten years from issue, and a bond trading above par should be evaluated on yield to worst rather than yield to maturity, which is frequently a difference of more than a full percentage point.
Credit quality is bimodal
The municipal market has a reputation for safety that is deserved by most of it and badly undeserved by a specific corner. Aggregate default rates for the asset class are low enough to be almost meaningless as a guide, because they average two populations that have nothing in common. General obligation debt of a state, and revenue debt of a water system with rate setting authority and no competitor, sit at one end. Continuing care retirement communities and land secured district debt for housing developments that have not been built yet sit at the other.
Ten year cumulative default experience by municipal sector
| Sector | Share of market | Ten year default rate | Typical recovery | Comment |
|---|---|---|---|---|
| State general obligation | 9% | 0.01% | Not observed | No state has defaulted on general obligation debt in the modern era |
| Local general obligation | 24% | 0.09% | Varies widely | Concentrated in a small number of distressed municipalities |
| Water and sewer revenue | 13% | 0.04% | High | Monopoly service with the power to set rates |
| Public power revenue | 8% | 0.12% | High | Some issues depend on a single generating asset |
| Healthcare and senior living | 11% | 2.90% | 35% to 60% | Supplies a large share of all municipal defaults by count |
| Land secured and industrial development | 6% | 6.40% | 20% to 45% | Project finance risk wearing a municipal label |
Shorecliff Research estimates from rated and unrated issuance, 1996 to 2026. Sector shares are of par outstanding and do not sum to 100% because smaller sectors are omitted.
Those last two rows are 17% of the market and the great majority of the trouble. A buyer who owns a diversified fund owns some of them, which is fine because the diversification works. A buyer who bought individual bonds from a broker on the strength of a yield that looked generous relative to a general obligation may own rather more of them than they realise, because the extra yield was the entire reason the bond was shown.
When a retail client brings me a municipal ladder they built themselves, the first thing I do is sort it by yield and read the top five lines. That is where the surprises are. Nothing in this market pays you sixty basis points more than the comparable for no reason, and the reason is always written down somewhere in the official statement.
Reuben Falk, municipal strategist at Harrow Lane Capital
Buying it without a trading desk
The second cost that individual buyers underestimate is execution. Municipal bonds trade over the counter in small lots at spreads that are not disclosed as a commission, because the dealer's compensation is inside the price. A round trip on a retail sized purchase costs considerably more than the equivalent transaction in a Treasury or a listed fund, and that cost is paid once on the way in and again on the way out if the bond is sold before maturity.
0.68%
Estimated round trip cost on a $50,000 retail municipal purchase
Shorecliff Research estimate from trade reporting data, measured against contemporaneous institutional prints in the same issue. Costs fall sharply above $250,000.
None of this argues against the asset class. For a household in a high bracket with a taxable account and a defined spending horizon, a portfolio of high grade municipals is one of the few places where the tax code hands over a genuine advantage rather than a complication. It argues for doing the one calculation that makes the market legible, checking the call, reading the sector, and buying in sizes where the dealer's spread is not the largest number in the transaction.
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