It’s prime time to lock in yields on this tax-free income play, UBS says

UBS doesn’t see the Federal Reserve embarking on rate cuts until September – and that means now is the time to snap up tax-free municipal bonds. The bank’s chief investment office sees no more than two interest rate cuts from the central bank this year, with the first one occuring in the fall. Accordingly, UBS sees the yield on the 10-year Treasury note sliding to about 3.85% by year end from its current level of 4.58%. Bond yields and prices move inversely to each other, so a decline in rates will come with price appreciation for the underlying issues. “Against that backdrop, we believe that yields on quality municipal bonds look attractive at current levels,” wrote UBS Wealth Management senior municipal bond strategist Kathleen McNamara in a report last week. “And there’s also potential for capital gains as the year progresses,” she added. The strategist anticipates that the bond market will likely price in a sequence of additional cuts going into 2025 and beyond, which will bolster muni bond performance. “Therefore, we remind investors that it would be prudent to take this opportunity to lock in higher yields on longer-dated quality bonds for a portion of their fixed income portfolios,” McNamara wrote. The kicker of tax-free income Muni bonds are generally backed by the full faith and credit of the issuer, which makes them less of a default risk compared to corporates. There’s a trade off for this safety measure: Munis tend to offer lower yields than corporates. But what makes them so appealing to high-net-worth investors is that they provide income that’s free of federal taxes – and if the investor resides in the issuing state or municipality, that income can also be free of state and local levies. Consider an investor who is in the top federal marginal income tax bracket of 37% and also facing the net investment income tax of 3.8%. If that individual bought a muni bond yielding 4%, he’d have to find a taxable corporate bond yielding 6.75% in order to get comparable results, according to UBS. “For investors residing in a state with a high personal income tax rate such as New York, California, or New Jersey, the [tax-exempt yield] on long-dated AA[-rated] munis can exceed 8%,” McNamara said. For investors who are snapping up individual issues, UBS is looking at a “barbell” strategy: That is, buying short-dated munis in the 1- to 2-year range with yields of about 3.5% and pairing that with longer-dated munis maturing in about 17 to 22 years. The short end of this barbell provides liquidity and an opportunity for reinvestment, while the longer end offers income and the possibility of capital gains, UBS said. Play the space with ETFs Investors can also add exposure to municipal bonds using exchange traded funds, as purchasing the issues themselves can be costly. Most munis are issued in minimum denominations of $5,000 – and cumbersome for do-it-yourselfers. The Vanguard Tax-Exempt Bond ETF (VTEB) has seen more than $1 billion in new investor cash so far this year, according to FactSet. It offers a 30-day SEC yield of 3.55%, and has an expense ratio of 0.05%. For investors residing in high-tax states, there are also state-specific muni bond ETFs. Consider that California residents, where the top income tax rate is 14.4%, could choose from the Vanguard California Tax-Exempt Bond ETF (VTEC) or the Franklin California Tax-Free Income Fund (FKTFX) . VTEC has a 30-day SEC yield of 3.17% and an expense ratio of 0.08%, while FKTFX has a 30-day SEC yield of 3.31% and an expense ratio of 0.6%. Be fee conscious as you shop for municipal bonds. Large diversified municipal bond funds can be cheap, but state-focused funds tend to be a little more costly. Consider that the iShares National Muni Bond ETF (MUB) carries an expense ratio of 0.05%, but the Vanguard New York Long-Term Tax-Exempt Fund (VNYTX) costs 0.17%.