Top earners pivot from Treasuries to municipal bond ETFs as tax arbitrage widens
With the 10-year Treasury offering a mere 2.6 per cent after-tax return for top-bracket filers, three municipal bond ETFs are capturing flows by delivering tax-equivalent yields between 5.9 per cent and 7.6 per cent.
High-income investors are increasingly reallocating capital from US Treasuries to municipal bond exchange-traded funds to optimise after-tax returns. The shift is driven by a significant tax disadvantage for top-bracket earners, whose after-tax yield on the 10-year Treasury, currently yielding 4.43 per cent, collapses to approximately 2.6 per cent after accounting for federal and net investment income taxes.
For the 2026 tax year, the top federal marginal rate stands at 37 per cent, with an additional 3.8 per cent net investment income tax applying to investment income. This results in a combined federal tax rate of roughly 40.8 per cent. For residents of high-tax states such as California, New York, or New Jersey, effective tax rates on Treasury income can exceed 50 per cent, further eroding real returns and making tax-exempt municipal bonds a more attractive proposition.
Three specific municipal bond ETFs are attracting these flows: the iShares National Muni Bond ETF (MUB), the VanEck High Yield Muni ETF (HYD), and the SPDR Nuveen Bloomberg High Yield Municipal Bond ETF (HYMB). MUB yields 3.5 per cent tax-free, offering investment-grade credit quality with negligible historical default rates in its focus on state general obligation and essential-service bonds. Its tax-equivalent yield for a top-bracket investor is approximately 5.9 per cent.
The high-yield options offer higher returns but come with increased credit and duration risk. HYD yields 4.32 per cent tax-free, with exposure to below-investment-grade bonds including tobacco settlement paper and Puerto Rico debt, translating to a tax-equivalent yield of 7.6 per cent. HYMB yields 4.55 per cent tax-free, tracking the Bloomberg High Yield Municipal Bond Index and excluding some of the most distressed names found in HYD, resulting in a tax-equivalent yield of around 7.4 per cent.
The tax arbitrage case for municipal bonds relies on the current tax framework, including the 37 per cent top bracket, which is projected to remain in place for 2026 under the One, Big, Beautiful Bill. While MUB serves as the benchmark for investors seeking tax exemption without credit complexity, HYD and HYMB cater to those willing to accept higher risk for superior yields. Investors seeking high-yield exposure without concentrating risk in a single index methodology may consider splitting allocations between HYD and HYMB.
