UBS Chief Investment Office believes that the Federal Reserve will not initiate any rate cuts until September this year. They anticipate no more than two interest rate cuts from the central bank, with the first one expected to happen in the fall. This projection has led UBS to suggest that now is the ideal time to consider investing in tax-free municipal bonds. The bank predicts that the yield on the 10-year Treasury note will drop to approximately 3.85% by the end of the year, down from its current level of 4.58%.
Municipal bonds are generally perceived as a safer investment option as they are typically backed by the full faith and credit of the issuer, reducing the risk of default compared to corporate bonds. While municipal bonds tend to offer lower yields than corporate bonds, they provide an attractive feature for high-net-worth investors. The key advantage of municipal bonds is that the income generated from these bonds is exempt from federal taxes. Moreover, depending on the investor’s residency, the income may also be free from state and local taxes.
For investors in the top federal marginal income tax bracket of 37%, purchasing a municipal bond yielding 4% provides comparable results to owning a taxable corporate bond with a yield of 6.75%. Moreover, investors residing in states with high personal income tax rates, such as New York, California, or New Jersey, could potentially benefit from tax-exempt yields exceeding 8% on long-dated AA-rated municipal bonds.
To maximize the benefits of municipal bonds, UBS recommends employing a “barbell” strategy. This involves investing in short-dated munis with yields around 3.5% for liquidity and reinvestment opportunities, while also acquiring longer-dated munis maturing in 17 to 22 years for income and potential capital gains. Additionally, investors can opt for exchange-traded funds (ETFs) as a cost-effective way to gain exposure to municipal bonds without having to purchase individual issues.
ETFs like the Vanguard Tax-Exempt Bond ETF (VTEB) offer investors exposure to municipal bonds with a 30-day SEC yield of 3.55% and a low expense ratio of 0.05%. State-specific municipal bond ETFs, such as the Vanguard California Tax-Exempt Bond ETF (VTEC) or the Franklin California Tax-Free Income Fund (FKTFX), cater to residents of high-tax states like California. These ETFs provide competitive yields and expense ratios while diversifying the investment across a broader set of bonds.
When selecting municipal bonds or ETFs, it is essential to be mindful of the associated fees. Large diversified municipal bond funds generally have lower expenses compared to state-focused funds. For instance, the iShares National Muni Bond ETF (MUB) has an expense ratio of 0.05%, considerably lower than the Vanguard New York Long-Term Tax-Exempt Fund (VNYTX) with a cost of 0.17%. Being fee-conscious can significantly impact the overall returns on municipal bond investments.
UBS’s recommendation to invest in tax-free municipal bonds presents an opportunity for investors to capitalize on potential gains amidst a backdrop of expected interest rate cuts. By leveraging the tax benefits of municipal bonds and employing a strategic investment approach, investors can enhance their fixed income portfolios and potentially achieve higher yields with reduced tax implications.