UBS predicts that the Federal Reserve will not reduce interest rates until September, making now the opportune time to invest in tax-free municipal bonds. The bank anticipates only two rate cuts this year, with the first one occurring in the fall. As a result, UBS expects the yield on the 10-year Treasury note to decrease to 3.85% by the end of the year from its current level of 4.58%. This decrease in rates will lead to price appreciation for bonds, making quality municipal bonds particularly attractive at their current levels.
Municipal bonds are generally considered safer than corporate bonds as they are backed by the full faith and credit of the issuer, resulting in lower default risk. While municipal bonds typically offer lower yields than corporates, they are appealing to high-net-worth investors due to the tax advantages they provide. Income generated from municipal bonds is free of federal taxes, and in some cases, state and local taxes as well. This tax-free income can significantly boost returns, especially for investors in high-tax states.
UBS recommends a “barbell” strategy for investors looking to maximize their returns with municipal bonds. This strategy involves purchasing short-dated municipal bonds with yields around 3.5% along with longer-dated bonds maturing in 17 to 22 years. The short-dated bonds provide liquidity and reinvestment opportunities, while the longer-dated bonds offer income and the potential for capital gains. By strategically combining these two types of bonds, investors can achieve a balanced and diversified portfolio.
For investors looking to gain exposure to municipal bonds without purchasing individual issues, exchange-traded funds (ETFs) are a cost-effective solution. The Vanguard Tax-Exempt Bond ETF (VTEB) has seen significant inflows this year, offering a 30-day SEC yield of 3.55% with a low expense ratio of 0.05%. State-specific muni bond ETFs, such as the Vanguard California Tax-Exempt Bond ETF (VTEC) and Franklin California Tax-Free Income Fund (FKTFX), cater to investors in high-tax states like California. These ETFs provide diversification and accessibility to municipal bonds without the need to invest in individual issues.
When investing in municipal bonds, it’s essential to be mindful of fees and expenses. Large diversified municipal bond funds typically have lower costs compared to state-focused funds. For instance, the iShares National Muni Bond ETF (MUB) has a minimal expense ratio of 0.05%, while the Vanguard New York Long-Term Tax-Exempt Fund (VNYTX) carries a slightly higher expense ratio of 0.17%. Investors should carefully consider these fees while building their municipal bond portfolios to maximize returns.
Tax-free municipal bonds present a compelling investment opportunity for investors seeking to generate tax-free income and diversify their portfolios. With the right timing, strategic approach, and consideration of fees, investors can leverage municipal bonds to achieve attractive returns while minimizing tax liabilities.