Jim Reber: Munis for all

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No need for tax-free bonds? Check out the value in taxable munis.

By Jim Reber, ICBA Securities


So, you say your community bank doesn’t own any municipal bonds? And you don’t need to read a column about an investment sector that has no relevance to your investment strategy? Because your bank is an S-Corp and passes through its earnings to the shareholders? Or because your bank is effectively owned by an employee stock ownership plan (ESOP)? Please don’t say it’s because your bank doesn’t have any income, which was the circa-2009 reason, but is thankfully a rare event today. Nonetheless, please keep reading because this column probably does have import for your community bank.

Whatever the reason, a good number of community banks have no need to shield income from income tax liability, even if the organization itself is profitable. Unfortunately for these institutions, tax-free munis are the most efficient—if not most profitable—way to avoid payment of income tax. It’s been documented here that the amount of tax-frees in a portfolio has a strong correlation to its performance. So, as my associates from Vining Sparks and I write and speak about high-performing investments, we eventually have to declare that a bond portfolio without tax-free munis is probably going to wind up in the bottom quartiles among its peers.

Note that I said “probably.” We may be in a new era of bond-sector allocation. What is different in 2020 from, say 2017? For one, thankfully, marginal tax rates are quite a bit lower. Tax-free weightings are down about 20% from their peak, and many—tax-paying—institutions are still replacing nontaxables with taxables.

For another, the taxable muni sector has seen enormous growth, so much so that supply has outstripped demand recently. And, as we know, supply gluts get corrected by prices falling enough to attract buyers; in bond-speak, this is referred to as “spread widening.” In some cases, spreads are wide enough so that taxables can be used as an alternative to tax-frees without a discernable drop in yield.

Numbers back it up

In another subplot, some crossover buyers of taxable munis have migrated from corporate bonds. Corporates and taxable munis have a lot in common: both are non-amortizing, neither are guaranteed by any appendage of the Federal government and an investor can pretty much pick the credit quality and duration of his or her choosing. The corporate bond market is many times larger than the taxable muni sector, so it has relatively better liquidity. As of 2018, the corporate market was more than $9 trillion and growing, whereas the entirety of the taxable market is about $485 billion, according to Bloomberg, or about 12% of all munis.

Education on Tap

Manage your balance sheet
ICBA Securities and Vining Sparks will host the 2020 Balance Sheet Academy on April 20–21 in Memphis, Tenn. Up to 12 hours of CPE are available. This is an intermediate level class for experienced portfolio managers. Learn more and register here.

But corporates also have higher risk-based capital weightings and a much higher default history. Moody’s Investors Service reports that from 1970 to 2018, rated corporate bonds had an annual default rate of more than 6% compared with 0.09% for rated municipals. Corporates have historically represented about 5% of the typical community bank bond portfolio.

More good news

First, here’s a review of a provision in the tax reform law from 2017. The act lowered corporate tax rates but also eliminated the ability of issuers to “pre-re” an existing issue. This was a strategy by which bonds that had higher-than-market costs were refinanced early by issuing more debt at lower costs, with the issuer later paying off the old debt as soon as it could be called away. The sunsetting of the pre-re strategy applied only to new tax-free debt.

As rates have fallen over the past year, many old bonds can now be pre-refinanced into taxable munis and still save the issuer some money. There also continues to be the shakeout by portfolio managers to right-size the tax-free segment in the current tax rate environment.

Nearly $70 billion of taxable munis came to market in 2019, almost double that of the year earlier. A lot of the supply has come from the pre-re activity. While some new demand has come from erstwhile corporate buyers and erstwhile tax-free investors, it hasn’t been enough to soak up all the new supply of taxable munis. Spreads are near an 18-month high, which is an indication of relative value (see graph below).

So, if your investment sector weightings can migrate out of corporates or tax-free munis, the taxable muni sector bears strong consideration. Supply is ample, yields and spreads are attractive, credit quality has been quite good, and this is probably a sector that will continue to grow. Regardless of tax structure, your institution could be in a position to take advantage of the taxable muni sector.

Education on Tap

2020 webinar series kicks off
ICBA Securities and its exclusive broker Vining Sparks begin their 2020 Community Banking Matters webinar series on Feb. 18 at 10 a.m. CDT. The topic is Positioning the Investment Portfolio for Performance. One hour of CPE is offered, and there is no cost to attend. Register here.

 

historical comparison graph

Source: Bloomberg/Vining Sparks


Jim Reber, CPA, CFA (jreber@icbasecurities.com) is president and CEO of ICBA Securities, ICBA’s institutional, fixed-income broker-dealer for community banks

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