This summer’s bumps in the equity markets have some investors refocusing on their bond positions. Bonds have traditionally been a popular vehicle for maintaining portfolio stability and generating income. However, with yields steadily shrinking over the past few years, fixed income has become less productive for boosting cash flow but still retains its allure as a stabilising mechanism. When risk markets fall on poor economic news or geopolitical instability, bonds often help lower overall portfolio volatility and protect principal value. In reviewing a portfolio’s fixed income component, taxable municipal bonds are one subsector which deserves a closer look.

Municipal bonds are synonymous with tax reduction for US citizens. In fact, the majority of municipal bonds carry below market interest rates due to their tax advantages for US taxpayers. However, within the broad sector of municipal bonds, taxable issues may be an interesting choice for many investors who pay little or no tax. While the universe of taxables is much smaller than tax-free issues, the volume of taxable bonds has been steadily growing and many individual issues are large enough to offer a reasonable degree of liquidity.

In general, municipal bonds are issued by local governments, such as cities, counties or public agencies either for general budget purposes or for more specific projects. Historically, the US government has exempted the interest on most municipals from federal taxation. Furthermore, the interest on municipal bonds is also exempt from local income tax within the state of origin. For example, an individual owning a municipal bond issued by the city of San Francisco would earn interest free of tax from both the state of California and the US government. For this reason, the yield offered on tax-free municipal bonds is usually significantly lower than a similar quality taxable bond. Investors are willing to take a lower yield in exchange for a tax benefit which could be as high as 45 percent of the interest earned.

Taxable municipal bonds, on the other hand, do not offer any tax reduction benefit and therefore must pay higher rates of interest to entice investors. Furthermore, the quality tends to be good on most issues which are backed by strategic public projects. The higher yields and generally strong credit quality make the sector an intriguing choice for investors anywhere in the world. The yields on taxable munis typically exceed comparable US Treasury bonds and often are better than yields on similar high-grade corporate bonds. For example, the average yield on a ten-year an “A” rated taxable municipal bond is 4.1 percent as of this writing according to Bloomberg data. This compares to a ten-year US Treasury bond now yielding around 2.5 percent.

Unlike tax-free munis, taxable issues are mainly issued to finance projects or activities that do not provide a major benefit to the public. Sports facilities, universities, special purpose districts and underfunded pensions are typical entities which issue these bonds. However, because they are not backed by the full taxing power of a government body, such as a general obligation bond, care must be taken to insure that the underlying credit is stable. In other words, the same due diligence necessary for corporate bond credits is applicable to these municipal bonds.

Demand for taxable munis has been quite strong in recent years. Notwithstanding the lack of tax benefit, issuers have had no trouble bringing bonds to market. The sector has actually been quite popular among institutional investors and mutual funds and issuance has steadily grown. According to Bloomberg data, the amount of bonds issued has increased from $25.6 billion in 2011 to $31.1 billion in 2013. This is about double the amount issued in 2007 and 2008.

In 2009 and 2010, the taxable municipal bond market saw a massive increase in deals, but one which is unlikely to occur anytime soon. In an effort to pull the US out of the Great Recession in 2009, the Build America Bonds (BAB) programme was implemented which encouraged a large number of entities to borrow new funds through bond issues partially guaranteed by the US government. Total bonds issued during the two-year BAB’s period exceeded $230 billion. The programme expired in December 2010 but many of those bonds still trade on the secondary market.

With interest rates hovering near historic lows and sovereign credits perhaps looking pricey, investors should continue to carefully weigh their fixed-income alternatives. It is my view that security selection will become increasingly important in achieving the best results from both fixed income and equity portfolios in the years ahead. Being positioned in the right sectors and securities which offer value will make a substantial difference in realised returns. New and seasoned municipal bond issues are worth investigating in this environment.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.