There's a small portion of the bond market that investors may have overlooked but now may want to consider—the taxable municipal bond market.

Most munis pay interest that is exempt from federal and potentially state income taxes. However, interest on some municipal bonds is subject to both federal and state income taxes. These bonds, known as taxable municipal bonds, generally pay higher interest rates than tax-exempt munis to make up for the lack of tax benefits.

Below are some of the primary reasons we think investors should consider taxable munis. But first, a quick introduction to taxable municipal bonds:

The main difference between a taxable municipal bond and a tax-exempt muni is that taxable munis pay interest income that's subject to federal and state income taxes, whereas tax-exempt munis pay interest income that's generally exempt from federal and state income taxes. They're often issued by the same issuer and therefore don't differ in credit quality. For example, issuers like the State of California, the New Jersey Turnpike Authority and the University of Michigan, just to name a few, all issue both taxable and tax-exempt munis. An issuer may choose to issue a bond as either a taxable or tax-exempt issue for a variety of reasons, such as the yield environment or to attract a different investor base to increase demand for their bonds.

Due to the different tax treatments between taxable and tax-exempt munis, we believe that taxable municipal bonds may be an attractive option for investors in lower tax brackets or for tax-advantaged accounts like an individual retirement account (IRA). Investors in higher tax brackets may still want to consider tax-exempt munis, as they may yield more than taxable munis after considering the effects of taxes.

1. Taxable munis offer attractive yields relative to tax-exempts.

Yields for taxable municipal bonds are attractive, in our view, compared to tax-exempt munis of similar maturities. For example, since January 2010, on average, an index of taxable municipal bonds has yielded 0.9% more than an index of tax-exempt municipal bonds. Only during a brief period in March 2020 when the market was very volatile due to the onset of the COVID pandemic crisis did taxable munis yield less than tax-exempt munis. Today, that difference is close to its highest point since January 2010.

2. Taxable munis are generally high in credit quality, like tax-exempt munis.

Another potential benefit of taxable munis is that they're generally higher in credit quality than other alternatives. For example, 79% of the taxable muni market is rated in the top two rungs of credit quality–AA minus or above.¹ This compares to 76% for the tax-exempt muni market and only 7% of the corporate market, as illustrated in the chart below.

This is notable for investors because higher-rated issuers tend to default—that is, to miss an interest or principal payment—less frequently than lower-rated issuers. For example, over a five-year period ending in 2022, 0.4% of Baa rated munis defaulted, according to Moody's Investors Service. During the same period, lower-quality B rated munis defaulted 26 times more often, at a rate of 11.7%.

Moreover, municipal bond issuers, which include issuers of taxable munis, tend to default less frequently than corporate bond issuers. Looking at the Baa rated cohort, the default rate for munis was 0.4%, compared with 1.5% for corporates.

However, taxable munis do have some risks. Here are two of the most prominent:

3. The relatively small size of the market

Although issuance has risen recently, the taxable muni market is much smaller than many other fixed income markets, as illustrated in the chart below. Smaller markets are generally less liquid than larger ones, like the Treasury market, which means that it can be more difficult to sell your bond if you need to. Therefore, we suggest that if you're considering taxable munis, plan on holding them until maturity. The smaller market and lower liquidity of taxable munis is also an issue for investors in funds like exchange-traded funds (ETFs) or mutual funds.

Due partly to the size of the market, there aren't many mutual funds or ETFs that invest solely in taxable municipal bonds. In fact, there is only one open-ended ETF that we know of that invests in taxable municipal bonds and doesn't use leverage. Leverage generally means using borrowed funds to try to amplify returns. However, leverage can also amplify negative returns. Bonds that are less liquid are generally more volatile in times of market stress.

4. A large portion of taxable munis are from smaller issues

Nearly one-third of all taxable munis are small issues and therefore not eligible to be included in the broad taxable muni index. This is important because passive strategies like ETFs that track the benchmark will generally not invest in these smaller issues which can reduce some diversification benefits.

5. The taxable muni index is sensitive to interest rate changes.

First, the taxable muni index has a longer average duration—which makes it more sensitive to changes in interest rates—than the tax-exempt index. For investments such as ETFs or passively managed mutual funds that simply track the index, investors are taking on greater interest rate risk with taxable munis compared to tax-exempt munis. This is the main reason taxable munis have underperformed other fixed income investments this year. If rates rise more than we expect, total returns for taxable munis would likely underperform their tax-exempt counterparts even more.

For investors in high tax brackets, we generally don't see value in taxable munis. However, investors in lower tax brackets or those investing a tax-sheltered account like an IRA may want to consider a small allocation to taxable munis to complement their other fixed income holdings.

Schwab clients can log in to their accounts and search for individual taxable munis using the "Federally Taxable" dropdown menu under "Search by Product" on Schwab BondSource on Schwab.com. Clients can also search for funds like ETFs or mutual funds on Schwab.com that invest primarily in taxable munis. If you need additional help, reach out to a Schwab Fixed Income Specialist for guidance in selecting the investments that are right for you.