The Tax-Exempt Train Rolls On

The obvious source for positive returns in bonds during 2021's robust economic recovery is high-yield, or junk, a category always known to piggyback on rollicking growth and booming oil prices.

But as usual, and despite the uptick in interest rates and all the apprehensions that inflation is about to stay stubbornly higher, tax-exempt bonds are also in the green. I like to say municipals are steely stuff. I am on the verge of upgrading them to titanium.

The numbers for 2021 are not spectacular. A clutch of broad-based municipal indexes is up 0.5% to 1%, exemplified by Standard & Poor's state general obligation index, at 0.6%. But its three-year annualized gain is 4.5%, and Vanguard's benchmark Total Bond Market ETF (BND) is at minus 2.4% for the year to date – hurt by its lack of tax-frees. (Prices and returns are through June 4.)

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Municipals' prices are not nearly as sensitive to interest-rate bumps as are Treasuries or corporate bonds. There is less trading, and more municipal bondholders stay put until maturity, so the prices are stickier until and unless rates seriously soar.

And the perception now is that high-income investors are due for big income tax increases, so they are frantic for shelters, and tax-free bonds are easy to buy. (For more on tax-wise investing, see How to Invest for a Higher-Tax Future.)

But tax-policy talk is always a questionable explanation for municipal bonds' success.

I have found that people just do not want a tax liability when it is optional. It does not matter whether their personal tax rate is low, they live in a tax-haven state, or Congress puts them into a combined 50% state and local bracket.

It also does not matter whether the yield on tax-frees is unusually low compared with what is available from taxable debt – which it is now, with triple-A muni yields at near-record lows relative to 10-year Treasuries. In some asset classes, this would trigger a burst of profit-taking and rebalancing. Not here. Repeat after me: Folks. Just. Hate. Taxes.

Prosperity is a Plus

There is another powerful force propping up munis in 2021: U.S. prosperity. Treasury bonds gain in value when banks, pension funds, foreign nations and other giant investors seek maximum safety and soundness; municipal bonds' good fortunes reflect healthy employment and consumer spending, robust business activity, and rising real estate sales and property values.

Hence, the S&P Infrastructure Plus tax-free index is up 2.3% so far this year – four times the gain in the index of state general obligations. Airport bonds are ahead 2.1%; hospital bonds, 1.9%; and toll-road bonds, 1.7%. Almost none of these bonds fell apart in value or missed payments a year ago, helped by sizable cash reserves.

Fitch Ratings did put the Pennsylvania Turnpike and the South Jersey Transportation Authority on negative watches – but has now removed them. Fitch forecasts U.S. toll-road traffic to get back to 2019 levels by the fourth quarter of this year. It may need to advance that target.

As for income, in April 2021, New Jersey Turnpike toll revenue exceeded April 2020's depressed take by 203%. There is a reason these are called revenue bonds.

Few mutual funds are devoted specifically to revenue bonds, but high-yield portfolios including the incomparable Nuveen High Yield (NHMAX, yield 4.6%) have a heavy share of them. The Nuveen fund has a year-to-date total return of 6.3%.

Closed-end BNY Mellon Municipal Bond Infrastructure Fund (DMB, $15, 4.3%) has returned 7.3% so far in 2021. After spending years at a discount, it now trades at net asset value – a fair price.

I've recommended these funds for years, but it's still not too late to buy.

We're climbing out of the economic shock of a lifetime, and nothing terrible happened to bond investors. Better times are rolling. Enjoy the ride.