As investors hunt for that perfect vehicle to reduce their tax burden, they may want to focus on maximizing after-tax return, rather than minimizing taxes.
Some investors, however, are quite comfortable with how lower-yield municipal bonds fit into their portfolios, with the benefits of a steady stream of tax-free income. And there is value there. But others, seeking more lucrative opportunities, need to look elsewhere in the fixed-income universe.
For example, assuming similar maturity and credit quality, investors may be better off in higher-yielding, taxable fixed-income instruments to maximize returns, on an after-tax basis, rather than lower-yielding, tax-free munis.
Even for an investor in the highest marginal tax rate, a corporate bond yielding 6 percent remains a much more favorable investment than a municipal bond with a 1 percent interest rate. The taxable investor keeps roughly 60 percent of the yield after paying taxes, so at 3.6 percent, the corporate bond still yields more than the municipal bond.
Even in the most onerous high-tax states like New York and California, investors able to find a 10 percent yield would still come out with about 5 percent yield, after taxes, but that still beats the 1 percent tax-free option.
According to a relative value metric we use that compares corporates and municipals, municipals had never been more expensive earlier this year. Hence, we think it makes sense for investors to constantly re-evaluate the relative attractiveness of municipal and taxable bonds and when appropriate, consider rebalancing their fixed-income holdings.
Investors looking to reduce their tax burden should examine their fixed-income portfolios and reassess the effectiveness of the traditional tax strategies they may be incorporating as well as the market and economic conditions. By not taking advantage of higher-yielding taxable bonds or strategies such as tax harvesting, investors may be leaving money on the table.
Andrew Chorlton is the head of U.S. multi-sector fixed income for Schroder Investment Management North America Inc. (SIMNA).