The Case for AMT-Free Municipal Bonds in a High-Yield, Tax-Efficient Portfolio

In a rising rate environment, investors are increasingly prioritizing tax efficiency to preserve real returns. AMT-free municipal bonds have emerged as a compelling solution for high-tax-bracket investors seeking to balance income generation with tax optimization. With yields climbing to multiyear highs and relative value metrics favoring munis over taxable debt and equities, the case for strategic allocation to AMT-free municipal bonds is stronger than ever.

Taxable Equivalent Yield: A Game Changer for High-Bracket Investors

The tax-exempt nature of municipal bond income creates a unique advantage for investors in higher tax brackets. For example, a 4% yield on an AMT-free municipal bond equates to a taxable-equivalent yield (TEY) of 6.54% for someone in the 38.8% federal tax bracket [1]. This calculation underscores the power of tax-exempt income in a rising rate environment, where even modest yield increases can translate to outsized after-tax returns. The S&P National AMT-Free Municipal Bond Index further illustrates this dynamic, with its TEY surging 66 basis points in early April 2025 alone [4].

Rising Rates and Relative Value: Munis Outperform in Key Metrics

The Bloomberg Municipal Bond Index has a yield-to-worst (YTW) of 4% as of June 2025, a level that has only been exceeded 4.9% of the time over the past decade [5]. After adjusting for tax savings, this yield outperforms corporate bonds for investors in the 22% federal tax bracket and above [5]. Meanwhile, the steepening of the 5s/30s municipal yield curve to 214 bps—a historically significant spread—suggests strong forward returns for long-end bonds [4]. This dynamic is particularly favorable for AMT-free munis, which avoid the spread premiums often seen in AMT-affected bonds.

Credit Quality and Supply Dynamics: A Favorable Environment

Despite elevated issuance driven by infrastructure needs, the municipal bond market maintains robust credit fundamentals. AAA/Aaa and AA/Aa rated bonds now comprise a near two-decade high of the market, reducing default risk [3]. The One Big Beautiful Bill Act, which preserved the $10,000 SALT deduction cap and muni tax exemptions, has further solidified the appeal of AMT-free munis for high-tax-state residents [3]. While short-term technical pressures have pressured yields, the long-end of the curve remains attractively priced, offering a 4.37% yield for a 10-year AMT bond (7.38% TEY for top-bracket investors) [1].

Strategic Allocation: Balancing Duration and Tax Efficiency

The VanEck Vectors Intermediate Municipal Index ETF (ITM), with a 7.05-year effective duration, exemplifies how AMT-free munis can mitigate rate risk while maintaining tax efficiency [1]. In contrast, long-end munis face dislocation due to heavy issuance, making active management critical to unlocking value [4]. Investors should prioritize high-quality, state-specific bonds that offer dual tax savings (federal and state) and avoid overexposure to long-duration instruments unless compensated by significant yield premiums.

Conclusion: A Pillar of the Tax-Efficient Portfolio

AMT-free municipal bonds are not just a niche play but a cornerstone for high-tax-bracket investors in a rising rate environment. Their ability to deliver tax-advantaged income, combined with strong credit fundamentals and attractive relative value, positions them as a strategic asset class. As the Federal Reserve contemplates rate cuts and municipal yields remain elevated, now is the time to rebalance portfolios toward these tax-efficient instruments.

Source:
[1] How the Trade War is Reshaping the Global Economy,
https://www.americancentury.com/insights/taxable-equivalent-yield-muni-bonds/
[2] Municipal Market: 2025 Mid-Year Outlook,
https://www.breckinridge.com/insights/details/municipal-market-2025-mid-year-outlook/
[3] Top 5 Muni Market Insights 2025: Mid-Year Update,
https://www.newyorklifeinvestments.com/insights/2025-municipal-market-insights-midyear
[4] A Historic Dislocation: Opportunity at the Long End of the Municipal Curve,
https://www.morganstanley.com/im/en-us/individual-investor/insights/articles/opportunity-at-the-long-end-of-the-municipal-curve.html
[5] Municipal Bonds: Mid-Year 2025 Outlook,
https://www.schwab.com/learn/story/municipal-bond-outlook