Taxing Decisons: Deciding Between Taxable and Municipal Bonds

In her latest white paper, Nora Pickens, Partner, Investment Strategy, explores how investors can choose between taxable and municipal bonds based on their tax situation. She discusses how high-tax-rate individuals often benefit more from municipal bonds due to their tax-exempt status, while tax-exempt entities should seek the highest yield available. She introduces two ratios for comparing yields: the Municipal/Treasury (M/T) ratio, with a typical breakeven tax rate of around 20%, and the broader Muni/US Aggregate (M/A) ratio, with a breakeven rate of 26%, useful for diversified portfolios. Here are some of her key takeaways:

• Tax Rate Drives Bond Choice: Investors’ tax rates dictate whether they benefit more from municipal or taxable bonds; high-tax investors typically gain from municipals, while tax-exempt entities should focus on the highest available yield.
• M/T Ratio for Bond Market Comparison: The Municipal/Treasury (M/T) ratio compares yields of AAA-rated munis to Treasuries to identify the breakeven tax rate, historically around 20%.
•  Broader M/A Ratio for Portfolio Context: For more diversified portfolios, the Muni/US Aggregate (M/A) ratio, with a breakeven tax rate of 26%, offers a more practical guide than M/T for comparing tax-exempt vs. taxable yields.
• State & Local Taxes Affect Taxable Bonds: Taxable portfolios, often subject to state and local taxes, make municipals more appealing for high-tax residents, further influencing bond choice.
• Regular Portfolio Review for Tax Efficiency: Investors should adjust bond allocations as income and tax rates change, blending muni and taxable bonds to optimize after-tax income.