This is Part 2 of Financial Advisor IQ’s five-part special report on how financial advisors can help their clients manage the tax impacts of their portfolios.

Municipal bonds and Treasurys are usually favored as safe, tax-exempt investments, but in the current low-yield environment, that’s gotten complicated. Yields on municipal bonds have dropped to the lowest levels in decades, while yields on Treasurys have also fallen to new lows and are expected to stay flat for the foreseeable future. 

“Historically, it’s a weird environment with low interest rates,” says Karl Schwartz, a CPA and CFP at advisory firm Team Hewins

The yield on five-year municipal bonds is 31 basis points, while real yields on Treasurys have been below zero for much of this year. Meanwhile, the real yields on some U.S. corporate bonds have dipped into negative territory. In the current “yield desert,” advisors are looking for alternatives. 

Eroding tax advantages 

Interest from municipal bonds is generally exempt from federal, local and state income tax — especially if the investor lives in the state in which the bond was issued. Similarly, the interest earned on Treasurys is exempt from state and local taxes, but is subject to federal income tax. Also, while interest income is typically tax-exempt, any capital gains are subject to federal and state taxes.   

Because of the tax advantages, advisors typically use these bonds in taxed accounts, such as brokerage accounts, to ensure taxes are as low as possible. Recent tax changes that make it more challenging to itemize deductions have made investment vehicles that reduce taxable income more attractive.  

Advisors first consider the clients’ tax rate and whether tax-advantaged bonds are still advantageous on an after-tax basis. Muni bond yields are usually lower than those of Treasurys as well as those of corporate and other taxable bonds. For most taxpayers, there is no longer much — if any — yield after taking taxes into account. Given the low yields, munis are usually favored only by high-net-worth clients with a high enough marginal federal tax rate. 

Even for clients in the 24% tax bracket — which would be married couples filing jointly with an annual income of $171,050 — there may be no tax advantage to investing in munis. After an initial selloff in March at the beginning of the Covid-19 pandemic, demand for munis rallied and bond prices rose, further lowering yields. 

Navigating risk  

Given the low-interest rate environment, which is expected to last for a while, advisors have been shifting clients into investments with better returns. Conservative clients may favor high-quality credit such as investment-grade bonds, agency mortgage-backed securities or some municipal bonds. 

For clients for whom munis still make sense, funds may be the way to go. Recent headlines about rising credit risk in municipal bonds have fueled concerns while the recent rally has made it trickier to uncover gems. Also, because of the many issuers and authorities, accessing and analyzing all the data takes expertise. 

“It doesn’t make sense to randomly purchase munis,” says Schwartz. “Use a mutual fund or hire a manager to build the portfolio. Default rates are low but it could happen that a handful of bonds you purchase directly may get into the trouble, and the last thing you want is a credit problem in a part of the portfolio that’s most conservative.” 

As with any fund investment, it’s critical to first look at the expense ratio. Credit quality is another factor to consider, especially amid increased concerns about defaults. 

For clients who are more willing to take on risk, there are high-yield bonds that carry a higher likelihood of default. But they are also more correlated to the stock market, so they’re not as useful for diversifying portfolios.

Another option is to put clients into dividend-paying equities specifically, the preferred shares of large financial institutions. The dividends from preferred stock are treated as qualified dividends and taxed at up to 20%, in comparison to the maximum federal tax rate on ordinary income of 37%. 

Despite the low yields, bonds still have a role to play in a well-diversified portfolio. Treasurys have a negative correlation to stocks and can act as a buffer. And even though yields are low, sitting in cash is not attractive either as interest rates are expected to stay low for years. 

Next: Guiding Clients to Make Tax-Smart Decisions