I have some good news for community bank portfolio managers who have grown weary of some or all the following conditions that have persisted since 2020:
- declining portfolio returns
- erratic cash flows
- call option exposure
- paltry yield spreads
Over time, one of the enduring determinants of investment performance is sector weighting. More specifically, the more a bond portfolio consists of municipal bonds, the more likely it will have above-peer yields. According to Vining Sparks, as of Dec. 31, 2020, municipal bonds made up 53% of top-quartile community bank portfolios. At the other end of the spectrum, the bottom quartile was only 9% invested in munis.
Historically, the number of bank-owned munis primarily determines a bank’s need to avoid tax liability. Some depository balance sheets have not had room for bonds, muni, or otherwise. Others have not been profitable enough to worry about that option. Still others, such as S Corps that pass earnings to shareholders, do not benefit from tax-free earnings.
Fast forward to the Tax Cuts and Jobs Act of 2017, which reduced corporate tax rates by around 40%. That was good news for bottom lines, but it lowered the effective yields on all tax-effected assets, such as traditional munis and bank-owned life insurance. Since that time, banks have shed about one-fifth of their tax-frees.
Another subtle but significant feature in that legislation was to no longer allow muni issuers to “pre-refinance” their outstanding debt into other, new tax-free issues. Refinancing older bonds into taxable matters would significantly impact the types of munis issued in the current environment.
In the 2020 calendar year, fully 30% of municipal bond issues were of the taxable variety, a decade-plus high-water mark. Less than ten years ago, taxable munis were but a blip on the new issue screen. They would constitute somewhere between 3% and 7% of total new issuances. The only year taxable munis exceeded 2020’s volume was 2010. And that was purely a function of the narrow window for issuing Build America Bonds (BABs), a type of taxable munis only available for issue in 2009–2010.
Now to the afore-promised good news. If your community bank is not much invested in munis, taxables could bring some welcome relief to the issues mentioned in the first paragraph. As supply has grown and the interest rate curve has steepened throughout 2021, taxable munis can serve several purposes, not the least of which is a respectable return. An investor can also now realistically hope for an issue that is reasonably proximate to its footprint.
A high-grade general obligation taxable muni will out-yield a bank-qualified (BQ) issue at any point on the yield curve. As of this writing, a 10-year AA-rated BQ bond will have a tax-equivalent yield of about 1.85%, whereas a similar-duration taxable will be about 2.10%. There are many reasons, including the relative lack of supply of BQ paper. Also, it bears mentioning that if S Corp banks have tax-free income, they may recognize higher tax-equivalent yields than their C Corp brethren.
What is the downside? As with any other taxable security, municipal bonds will have a higher degree of price volatility than tax-frees. However, the additional price risk is less than it used to be back in the era of 36% marginal rates for C Corps. It is unknown what the impact of higher marginal tax rates will be on the tax-free muni market, but higher rates should be supportive of tax-effected assets.
In the meantime, the growing supply of taxable munis should continue to produce attractive yields. The amount, both in absolute dollars and for a given issue (which is not limited to $10 million per issuer per year that BQs are), should produce more than adequate liquidity. The benefits and availability of taxable munis should appeal to the many community banks looking for the right combination of risk and reward.