Tax rates are an important consideration in fixed income asset allocations. Many investors in high tax brackets assume they should be invested entirely in tax-free municipal bonds, while tax-exempt investors (e.g. foundations, pensions funds) ignore tax-free bonds altogether. In both cases, investors would be better served to consider a more balanced approach, focusing on the potential after-tax return and risk of all fixed income sectors.
Tax-exempt investors can benefit from “crossingover” into tax-free municipals when municipal bond yields rise to abnormally high levels relative to taxable bonds. Conversely, taxable investors can benefit from the crossover trade in reverse: i.e., buying taxable securities when municipal bond yields are unusually low relative to taxable bonds. In each case, both the relative yields and the potential for the markets to return to a more “normal” yield relationship are important.
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