Shifting Market Dynamics

Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.

When constructing a fixed income portfolio, product choice depends on a range of factors. Some of these factors are investor driven while some are market driven. Variables such as risk tolerance, liquidity needs, account type, and tax bracket are determined based on the individual. Market driven factors include a range of items, such as product availability, liquidity, shape of the yield curve, general interest rate levels, and the yield relationship between various products. Factors based on the individual investor’s situation are generally more stable and easily understood for an investor. Market factors are constantly changing and require monitoring, analysis, and flexibility by the investors when it comes to choosing appropriate investments.

Taxable Equivalent Yield

The relationship between municipal bonds and taxable bonds has experienced a notable shift recently in a way that could have a meaningful impact on investor decisions. Generally, high tax bracket investors are best served by purchasing municipal bonds because the tax benefit that they receive overcomes the lower nominal yield. Simply put, the taxable-equivalent yield of municipal bonds is generally the most attractive opportunity for high tax bracket investors. For most of 2024, this has not been the case for municipal bonds in the short maturity range. This part of the municipal curve has been so “rich” (relatively higher priced) that even investors in the top tax bracket could achieve higher taxable-equivalent yields with corporate bonds compared with what they could get in municipal bonds. Over the past week, this dynamic has shifted back towards a more normal relationship where municipal bonds might make sense again across the entire yield curve.