LIZ ANN SONDERS: I'm Liz Ann Sonders.

COLLIN MARTIN: And I'm Collin Martin

LIZ ANN: And this is On Investing, an original podcast from Charles Schwab. Every week we analyze what's happening in the markets and discuss how it might affect your investments.

COLLIN: Well, hi, Liz Ann, here we are again. Lots to talk about this week. We're recording in the middle of the week right now. And it's been a pretty interesting last handful of days where we've seen Treasury yields rise pretty sharply. I think I can say that. But we've also seen the stock market impact a little bit. And we've seen the S&P 500® has come down a little bit from last week's high. So what do you think's going on there? Do you think it's related to, you know, higher yields and the idea that maybe you were in this "higher for longer" period?

LIZ ANN: I do think so, Collin, and I've often talked about the importance of your world as it relates to my world. And Kathy and I used to talk about that quite a bit, that I think you can't really have a full understanding of what the market is doing or is going to do without paying attention to what's going on in the bond market, and in particular I track all different time period correlations between the 10-year yield, which is the one that has the most significant impact directly on the equity market, so the correlation between moves in the 10-year and moves in the equity market, and on a rolling 30-day basis, that correlation has gone back into pretty deep negative territory. So bond yields up, stock prices down. And it's not really about the level, but it's the direction and the speed that tends to impact the market.

And I think that there's also a sense that some of these inflation pressures might be more entrenched and not solely driven by the war in Iran and energy prices. You've seen growth in money supply that has picked up recently. So there's a lot of those, you know, old school Milton Friedman folks out there pointing to that as being one of the underlying drivers of maybe longer-term inflation, and the thing I've been thinking about again, and you were, I believe, part of a … it's really early where you are, so you may not have gone through your full inbox yet. But I sent a note out to our collective group here about something I've written about and spoken about for quite a few years, this notion that the so-called Great Moderation Era, which was the secular era that spanned from the mid-to-late '90s up until the inflation spike began in 2022, when it was an era marked by largely disinflationary trends, not a lot of inflation volatility, not even a lot of economic volatility, massive globalization that contributed to lack of inflation volatility.

And one of the defining characteristics of that era was actually a positive correlation between bond yields and stock prices, with the exception of the 2008 period. And that's because bond yields were keying more off the growth side of the equation and less off the inflation side of the equation, so higher growth without the attendant risk of a spike in inflation. That's sort of nirvana for the equity market. But I am wondering, and I have been for a few years now, whether we may be already in, if not transitioning into, a secular era that maybe doesn't look exactly like the era that preceded the Great Moderation but maybe has flavors of it. And I called it for a long time the "Temperamental Era." And it was really the period spanning from the mid-'60s to the mid-'90s.

And it was a period marked by the opposite of what we had in the Great Moderation, much more inflation volatility, more economic volatility. And in that 30-year span, with very few exceptions, the correlation between bond yields and stock prices was negative. And that's because the moves in bond yields were driven more by what was going on the inflation side of things, less on the growth side of things. So higher inflation, spikes in inflation, many times, not great for the equity market. So I'd love your thoughts on that too, either as it relates to the relationship to the equity market or whether you think we are in some sort of secular environment of higher, longer-term yields.

COLLIN: Yeah, I think I lean more towards the latter. And this is something me and the team, we're discussing right now. And, you know, it's almost like we were hardwired for a while to think that yields were just going to be low for a while. You know, we were in this period, like you mentioned, after the financial crisis, where the Fed held rates roughly at zero. They also used their balance sheet. Inflation stayed very low. And I think a key point that you also mentioned, low and not volatile, you know, very stable, very few surprises. And we kind of got hardwired that, "Oh, we're in this low-interest rate environment right now." And when we look at what's happening lately with the 10-year Treasury yield rising, you know, over 4.6%, the 30-year at close to 5.2%, its highest level since 2007, I think some people think, "Oh well, maybe this is an opportunity, because yields are probably going to go down." And I don't think that's necessarily the case right now.

And I do think a lot of it comes down to the volatility of inflation and maybe we're in some sort of different regime right now. If we go back before the financial crisis, inflation was generally higher and more volatile. The Fed did not use its balance sheet to kind of suppress long-term yields. And this is something we talked about on last week's podcast, but it seems unlikely the Fed will be doing that again, knowing that Kevin Warsh is coming in. So maybe we are in this higher-interest-rate, higher-long-term yield era, because when I look at kind of the whole landscape, I see way more factors that should keep yields elevated than should pull them lower anytime soon. To pull them lower, I think we need to see growth start to meaningfully slow. And we just haven't really seen that yet.

But with inflation moving in the wrong direction with a very cloudy outlook, with deficit concerns still very much present with global bond yields rising, yeah, I think we could be in this "higher for longer" era. And on the idea of, "Hey, is this an opportunity now?" like I alluded to before, if you look at the difference between, say, the three-month Treasury bill yield, which a lot of cash and cash-like investments are based off—money market funds, short-term CDs, things like that—and you look at what the 10-year yield offers above that, it's close to one percentage point, or 100 basis points. And that's risen lately. But again, if we go back to previous eras, it's been much higher.

So I think that's something to look at too, that in an economy where inflation is high and uncertain, if the economy is still growing, there should be a premium to be lending to the government or to hold long-term bonds. So very, very interesting situation we're in right now.

LIZ ANN: Yeah, Collin, you mentioned Kevin Warsh, who's about to be sworn in. You know, another facet maybe of this is that it is very, very common for a new Fed chair to get tested by the markets quite often, pretty consistently in terms of things like subsequent three-month drawdown in the equity market, sometimes by the bond market, sometimes by both. So I think there may be something at play there. My guess is he's going to find it very difficult to sing a really dovish tune in light of, not just the fact that neither side of the Fed's dual mandate is suggesting easier monetary policy, but in even his favorite version of inflation, which is trimmed mean, which takes out some of the volatile components, not just the food and energy typical, you know, headline-versus-core.

So do you think he's going to have to sort of change his tune or change the mindset of people who have assumed he's just full-on dove flying into the seat of Fed chair?

COLLIN: Yeah, how about "all the above" maybe? I do think he's going to, it'll be really interesting to hear from him when he is officially Fed chair, which I think believe comes this Friday after this episode will be released. Cause we haven't heard much from him, and we've talked about this a lot. In his congressional testimony, he wasn't uber dovish. You know, he wasn't really pounding the table about the need for lower rates, and knowing that, you know, historically he's been considered an inflation hawk, very worried about higher inflation over time, the impact of the Fed's quantitative easing and what that might do for inflation. So if we're in this environment where inflation's high and rising, I find it really hard to believe that he's going to come in and try to pound the table for lower rates or try to convince the committee members otherwise.

Now, you mentioned various inflation readings that we can look at. So Kevin Warsh has mentioned the idea of trimmed-mean inflation indicators. There's no shortage of inflation indicators that are out there. There's headline, there's core, which we talk about a lot that excludes the volatile food and energy prices that you mentioned. And then there's trimmed mean that kind of throws out the highest and the lowest readings. Is one better than the other? You know, probably not. They're all part of the same picture. I think if you look at trimmed means, you know that that might not necessarily be indicative of what our experiences are. Everybody's inflation experience is different depending on where you live, your age, what you're spending on. But to point to something that maybe suggests inflation is lower, I don't know how good of a look that will be. It's almost like …

LIZ ANN: But even trimmed means are up. So it's not like that you can point to those and say, "See, you know, nothing to see here, no inflation problem."

COLLIN: Yeah, they're still … I think they're below headline and core, but you're right …

LIZ ANN: They are, but still rising, right, right.

COLLIN: They're moving in the wrong direction. So how do you … it's a good point. Well, and that, I think, goes to the idea of the challenge that Warsh will have if he's inclined to try to influence the committee to lower rates. How do you do that right now? You know, our outlook for a while had been maybe the Fed could cut rates later this year. That seems much more unlikely now with still no progress in the Middle East, with inflation high and rising, oil and gas prices high, zero rate cuts and extended pause seems much more likely for us.

LIZ ANN: Yeah, and Collin, I think you're absolutely right. There's now a rate hike priced in by the end of the year. I think let's just suspend reality and think about, if Warsh is able to convince the majority of the committee to cut rates, I got to think, absent a significant change in the environment, that the bond market wouldn't like that, things, longer-term yields would not say, "Oh yay! Let's drop from here."

COLLIN: Yeah, totally agree. The economy is doing OK right now. I don't think the economy has an interest-rate problem. And if the Fed were to lower rates right now, which as we know, that only influences the short-term borrowing market, but you'd probably see businesses begin to issue more debt at lower interest rates and maybe that spurs more business spending. It would just spur more demand, I think, if they start to borrow more at those low interest rates, which, coincidentally would probably send longer-term yields higher, if inflation expectations rise. I think there's really no need right now in the here and now to be doing anything to Fed policy. I think the best plan of attack is for the committee to see how things evolve, especially as we go through the summer, see if there's good or hopefully not, but hopefully bad news, we don't want that in the Middle East, to see what is the outlook look over the next, you know, six, nine, 12 months, and beyond.

LIZ ANN: All right, Collin, so we do have a guest this week, and he works very closely with all of us, but particularly closely with you. So give us an introduction.

COLLIN: Yeah, absolutely. We have my colleague Cooper Howard joining us. He's a member of our fixed income research and strategy team. He's a fixed income strategist focusing on the municipal bond market, primarily. He's joined this podcast a number of times. I'm really happy to have him join. He's also a Chartered Financial Analyst® charterholder.

Hi, Cooper, thank you so much for joining us.

COOPER HOWARD: Thanks for having me, Collin. I'm excited to be here.

COLLIN: Well, I'm excited to have you here because, you know, I tend to focus more on the taxable markets. I talk a lot about the Federal Reserve, talk about the Treasury market, the direction of Treasury yields, because that makes a lot of headlines. But today we are going to focus on municipal bonds. And I think municipal bonds are super important for a lot of our clients at Schwab, a lot of individual investors. So I think it's important to kind of start with the basics. So let's start with a very high-level overview about what are municipal bonds and how are they different from stocks or Treasury bonds.

COOPER: Yeah, so at the most basic level, Collin, a municipal bond is just that: It's a bond. So just like other types of bonds, it pays you a set rate of interest, and usually it pays you a principal value back at maturity, assuming that it doesn't default. Now where it can differ from different types of bonds is the type of issuer. So municipal bonds are issued by cities, states, local governments, and they're often used to fund infrastructure projects.

So I myself am oftentimes a podcast listener. I listen to this podcast, other podcasts, and when I listen to podcasts, usually I'm out trying to do some sort of activity. I might be on a run or something like that. And I bring that up because that is what municipal bonds are oftentimes used to pay for: the roads that you're running on, the path that you're running through, the school that you're running past, the hospital that, if you sprain your ankle badly while running, you might have to go to.

So that's really where a municipal bond comes into play. And one of the benefits of municipal bonds is that they pay interest income that's generally exempt from federal income taxes. So at very high level, it's just a type of bond that has tax advantages relative to other types of fixed income investments.

COLLIN: Let's build on that a little bit because we talk about the appeal of municipal bonds. And when we talk about the appeal, we usually talk about their attractiveness for higher earners, high-income earners. So how does your income play into your decision to buy munis or what sort of account to hold munis in, given that tax-exempt status you mentioned before?

COOPER: Yeah, so it really boils down to one, what type of account you're investing in, and then also what is the tax rate that you're being charged on that interest income. So generally speaking, the type of investment account that you're investing in really matters. And that's because if you're investing in something like a taxable account, the money that you earn, that interest income is subject to ordinary income taxes. And that can range from various different things to a very low tax bracket all the way up to, say, a higher tax bracket.

And for municipal bonds, because they pay interest income that's generally exempt from federal income taxes, and even if you purchase one from your home state, it may also be exempt from state income taxes, the yields that they offer are often lower than that of a comparable corporate or a Treasury bond because of those tax benefits. So I wanna use an example of kind of how those tax benefits come into play.

We're just going to assume for simple math purposes, this isn't accurate, but it's for math purposes, assume that a municipal bond yields about 4%. So if you invest $100, you're going to get $4 on it. Or let's assume that you invest $1,000, you're going to get $40, if you invest in a municipal bond. If you invest in another type of bond that's fully taxable, let's assume that you can get 5% on that. So you invest $1,000 in the other type of bond, you're going to get about $50 in that.

Now let's take it to a taxable investor. And we're going to use two different types of investors, Collin. First is going to be one that's in a low-tax bracket. I'll choose 10%. And then the next one's going to be in a higher tax bracket. Let's choose 40%, for example. So that investor who's in that 10% tax bracket, they have to pay $5 of taxes on the $50 of income that they receive. So their net amount that they receive is actually $45. That's that take-home amount. It makes sense for them to invest in a taxable bond, pay the taxes, and then they get $45 rather than a muni to where they'd get about $40.

Let's assume that it's an investor who's in a higher tax bracket, that 40%, for example. Now they pay 40% of the $50 of income that they receive, so they pay $20 of taxes, and they take home $30. In this example, it'd be much better for that investor to consider investing in muni bonds rather than taxable alternatives, because after taxes, their take-home amount is higher in the muni bond than it is in the taxable bond.

COLLIN: Cooper, when you're talking about that example, you're talking about a 40% tax rate. Now that's above the top federal tax rate. So I assume we're talking about a federal and state tax combined rate. Is that right?

COOPER: Not exactly, because actually, so the top tax bracket federally is 37%, but also there's another 3.8% ACA tax on investment income. And ACA stands for the Affordable Care Act. So all of sudden you get to a top federal tax bracket of 40.8%. But if you add in state income tax, and if you're in a high state tax like New York or California, that can actually boost you up to an over 50% all-in tax bracket.

So also considering other applicable taxes, not just your federal tax rate, but state and local government taxes is also another very important piece about considering munis. And I'd highlight, I mentioned this earlier, but it's a very important piece, is that if you purchase a municipal bond, generally speaking, from another state, usually you have to pay state income taxes on that. So what we've found is that because of the state tax benefits, many of our investors have a preference for buying munis from their home state. And if you are in a very high-tax state, say California or New York, we think that that can really make sense. For most investors in other states, we'd actually suggest that they buy munis from outside of their home state, even though they may have to pay some state taxes on that interest income, the diversification benefits really outweigh that additional tax they may have to pay.

COLLIN: Now on the topic of state income taxes and how you're considering or what states to consider, I often hear about the triple tax exemption. So that I think is that when you're considering a muni from your home state, it would be exempt from state, local, and federal taxes. Is that right?

COOPER: That's correct. So in some situations, like New York, for example, New York City has a local tax. And if it's a bond that's purchased from the city of New York or one of its localities, then usually it's exempt from state, local, and federal income taxes. There are some other instances that come into play. And I think this is also a very important piece is, if you are an investor who is considering purchasing municipal bonds and looking at individual bonds, really do take the opportunity to look at: Is it exempt from state, local, federal income taxes? How does that apply to my situation? If necessary, you can pull in a specialist that can help determine that for you, or even your tax advisor can look over your personal situation to help out with that.

COLLIN: Yeah, that makes a lot of sense when you're investing in anything, whether it's taxable, tax exempt. You want to see what's my after-tax, my take-home income here. So always run the numbers and work with people that can help you, of course.

So one kind of major issue, or when I hear you think about munis, I tend to break them up into two categories. I think it's pretty common that most people think about it this way. We have general obligation bonds, and we have revenue bonds. What's the difference between the two, and do you prefer one over the other?

COOPER: Yeah, so really the difference between the two is how they derive their income sources. So general obligation bond is usually backed by the full taxing authority of that issuer. So for example, a state, a state can levy income taxes. That's how they derive their revenues off of it. Local government that might be backed by property taxes. And that's how they derive their revenues from it. A revenue bond is usually backed by the revenue-producing ability of that specific issuer.

So for example, think of a healthcare issuer, a group of hospitals, for example, that's where they get the money to pay the bonds back. Another example might be higher education. So a big university system might derive the revenues to pay the bonds back. Now, the difference between the two is because general obligation bonds are usually backed by the full taxing authority of that municipality, they tend to be much higher rated.

So a credit rating is really just a company's view of how likely is it that they're going to be able to continue to meet their interest and principal payments. Credit ratings for the revenue bond market tend to be much more diverse. So there's also a fair amount of higher-rated, a fair amount of lower-rated investment-grade issuers in the revenue bond market. I don't have a preference on one versus the other. Really, what I would suggest investors do is understanding what is the revenue that is backing the source of that bond? How are they deriving that? And then what is the risk relative to the reward?

And what I mean by that is how much yield are you receiving as an investor, relative to how volatile are those cash flows? So for example, a type of a revenue bond issuer would be a water and sewer utility district. Now, water and sewer utility, that's usually one of the first bills that we're going to pay, regardless of if we go into a recession or not and how the economic outlook is. So that tends to be a very highly rated, relative to other parts of the market, pretty secure part of the revenue bond market. So that's not to say that all revenue bonds are very highly rated and secure. It's just to say that some revenue bonds tend to be highly rated, and it makes more sense to look at what is backing that bond, than to paint the whole market with the same broad brush.

COLLIN: Cooper, when we're thinking about evaluating the relative attractiveness of munis, there's something that I know you focus on a lot, the muni-to-Treasury ratio. Can you give us an overview of what that is and what those ratios are signaling right now?

COOPER: Yeah, so the muni-to-Treasury ratio, it's one of the more common metrics that many municipal strategists and participants look at. And really all that it is, is it compares what is the yield on a AAA-rated municipal bond—and that's an important piece, a AAA-rated municipal bond. So it's looking at the very highest credit quality of the market, relative to the yield on that of a Treasury, before considering the impact of taxes.

So just to use an example to make math simple, let's assume that a municipal bond is yielding 6%. It's not, but let's assume that. And let's assume that the Treasury is yielding 10%. It's not. But if you divide 6 divided by 10, you get 60%. And that would be the muni-to-Treasury ratio of that. So really where we're at right now is 10-year muni-to-Treasury ratios are near about 65%, if you will.

That's closer to its three-year average. So what it's suggesting is, relative to the Treasury market, relative to the higher-rated portion of the market, munis are roughly valued. So about fairly valued right now. That shifts if you look at different ends of the maturities spectrum. So if you look at a two-year maturity, it's about in the low 60s. You look at a 30-year maturity, it's near about 90%.

So what that's suggesting is that there's more value in longer-term munis, relative to Treasuries, than there is for shorter-term munis relative to Treasuries. Now that's not suggesting that all of our clients should go out and buy 30-year munis. That's not … usually not a prudent strategy, but it is saying that if you are wanting to add longer-term bonds, and you are in a higher tax bracket, generally speaking, there's a little bit more of an attractive opportunity further out the yield curve.

The other thing that I'd highlight right now is, going back to my point about this being AAA-rated municipal bonds, is that there is some opportunity to add on some lower-rated issuers. And we're not talking about going down into junk municipal bonds or high-yield municipal bonds. It's maybe taking on some credit risk of a, maybe that's not a AAA-rated issuer, maybe it's a AA-rated issuer or even a single A-rated issuer.

And because they are lower rated, they're going to offer a little bit of a spread, a little bit of an additional yield compared to that AAA-rated issuer. And therefore, that's one way you can get a little bit higher of a yield.

COLLIN: Let's stick on the topic of credit quality. And I know this is something that you and I talk about a lot, in that the credit quality of the municipal bond market is a lot higher at an index level than what we see in the corporate bond market. So the corporate bond market, which is a market that I tend to focus on, most of the bond holdings in the Bloomberg U.S. Corporate Bond Index, which is the benchmark index of investment-grade corporate bonds, about 90% of the bonds in that index are rated single A or BBB, so the lowest two rungs of the investment grade spectrum. We see much higher ratings in the muni index.

So talk to us a little bit about that and then how that kind of reflects the point you just made about if you're willing to take a little risk to maybe consider slightly lower ratings.

COOPER: Of course. So the piece about the market structure is an important one, Collin, because to put numbers behind it, about seven out of 10 municipal bonds that are in the Bloomberg Municipal Bond Index, which is a very broad index of most municipal bonds that are out there, are either AA-rated or AAA-rated. And that's the top two rungs of investment credit quality. And that's actually been improving over the past few years. So the strong are actually getting stronger, I should say. And really how that's important is because it tends to be that higher-rated issuers don't default as frequently as lower-rated issuers or miss an interest or a principal payment. And I think one of the reasons why the muni market tends to be much higher rated than the corporate market is due to the essentiality of the revenue streams that municipalities rely on. So think things like income taxes.

Generally speaking, we're going to pay our income taxes. Water and sewer revenues, we're going to pay those as well. Higher education, in many instances, those are viewed as very important pieces to it. And unlike a corporation, they really don't have to compete for clients or customers or additional sources of revenue. If necessary, they can just raise taxes and use that to help pay off some of their debt that's outstanding.

Obviously, there's a cap on how much you can raise taxes and you start to lose a tax base, but maybe that's a topic for another conversation or another question. But I think that's one of the big important pieces about how to look at credit ratings and how credit ratings in the muni market and credit quality differs from that of the corporate market.

COLLIN: I think that's a good point. So if you're a muni investor, and like you said, you're willing to take a little bit more risk and consider, say, a single-A rating or a BBB rating, you're really just coming down to similar ratings that corporate bonds have. So stepping down in credit rating is … you might be taking similar risk than what you're getting as being the average corporate bond investor.

COOPER: I'd say yes and no. Yes, looking at it from the credit-rating perspective, no in the sense that the BBB-rated portion of the muni market is a very small portion of the market. So you're taking on different risks. Liquidity risk would be one of the risks that comes to mind, when thinking about that part of the market. And also the risk that it receives a downgrade and drops into junk-rated status.

Many funds and strategies that are out there have a mandate to where they can only invest in investment-grade municipal bonds. And so if it gets dropped down to a junk-rated rating, they may not find that bond attractive, they may not want to purchase that bond, and therefore it might be a little bit more volatile to price fluctuations than another that would be a little bit higher rated. So I agree with you that dropping down into lower-rated, say, single-A, BBB, from a credit perspective is akin to the corporate market, but also consider the liquidity and potentially other risks that you might be factoring in or taking on.

COLLIN: That's a great point. BBBs make up such a large chunk of the corporate bond market. A lot of corporate CFOs or treasurers appear to be comfortable with a BBB rating, even if they were to get downgraded. The corporate high-yield bond market is relatively liquid, less liquid than investment grade. Seems like that's not the case. That's a really good point about when you are moving down in credit quality.

I want to touch more again on credit quality, but talk about actual fundamentals a little bit. We've talked about credit ratings, but when we think about munis, what drives credit quality in terms of revenues earned by the municipality, for example, and what do those fundamentals look like today and how has that evolved since the pandemic?

COOPER: Yeah, so it is a lot on the revenues that that municipality is receiving, the expenses that they have, the management profile that they have put into place. So there's a lot of different factors that credit rating agencies look at. And there's actually three major credit rating agencies. There's Fitch, there's Moody's, and S&P. There are others, but those tend to be the ones that get the most attention. And they assign a grade to that issuer based off of the outlook for it based off being able to meet its interest and principal payments.

And I would say that looking at those grades, that credit quality of the market as a whole has been improving over the past few years, especially since the pandemic. The major reason for that is that tax revenue surged post-pandemic. And also there was a substantial amount of fiscal aid that was provided to state and local governments following the pandemic. There was so much fiscal aid that was provided that they were able to … many states were able to actually sock that away. And so they socked it away into their rainy-day funds. And a rainy-day fund, it's akin to just a savings account like you or I might have. And if there was some problem with our revenues, some problem with our income, we could tap into our savings account and use that to supplement it.

States have something very similar. If there's a slowdown in their revenues, they can tap into their rainy-day fund and use that to supplement their missed revenues. So part of the reason why you saw that strength in the market over the past few years is because of that federal aid that was provided to those state and local governments. Now that's since ended. So many state and local governments are having to kind of make up for that lost revenue in various different ways. Some that chose to save that quite a bit, they don't really have to make up for it that much because they just may not save as much as before.

But others that begin to spend that revenue or did spend that fiscal aid that they were provided, they're having to figure out other revenue sources to help manage that going forward. So the thing that we're seeing in the market today is kind of those bad actors that were pre-COVID are starting to re-emerge as some of those bad actors right now. Now, do we think that this is a broad risk to the overall market and it's going to lead to a substantial amount of downgrades or defaults? No, I don't think that is. But I do think that there is a little bit more of a divergence among credit quality among different types of issuers.

COLLIN: I really like that point. When we think about municipal bonds, obviously very, you know, relatively high credit quality, high ratings, but it is important to highlight that there are some risks in there and the risks can vary a little bit. I want to kind of bridge two topics together now. We talked about the relative attractiveness of munis relative to Treasuries before, but then we touched on the credit quality and how the credit ratings relate to say the credit ratings of the investment-grade corporate bond market. So let's say you're a taxable investor considering munis or corporates. How do they stack up?

COOPER: Yeah, so considering munis versus corporates, one, yes, you want to consider what account you're investing in, but then also you want to consider what tax rate that you're being taxed at. So one of the metrics that I commonly follow is called a breakeven tax rate. And it's really what is the tax rate that you would have to be at for a corporate bond after taxes to yield the same amount as a generic municipal bond. And right now that's about 33%. So what that's saying is that if you're in an all-in tax rate, that's federal, that's state and local, that's every tax that's applicable to your interest income, if you're at below 33%, on the average corporate bond, can actually probably get a higher after-tax yield than the average municipal bond.

If you're above 33%, then the average municipal bond is going to yield more than the average corporate bond after taxes. And that's about where we have been over the past three years. That metric has been increasing recently. So it suggests two things. It suggests that valuation in the muni market relative to corporates has been weakening, so it hasn't been that strong as it has been in the past. But given that we're very close to the long-term average, that's not to say that munis relative to corporates are unattractive. The other piece that I'd also highlight, and I kind of emphasize this as talking about the average corporate bond, average municipal bond, is that those two markets aren't really average for one another, so they're not exactly comparable to each other, like we discussed about credit quality.

So if you are an investor who's a little bit more conservative, a little bit higher of a tax bracket, even if it might not be this 33% tax rate that does fluctuate over time, then maybe still consider municipal bonds relative to corporates.

COLLIN: I like the way you laid that out. Every situation's different, right? So we're talking about averages here, but every investor, anyone who's listening to this is going to have their own tax rates subject to different taxes depending on where they live, state, municipality, and the such. So I think it's important to understand that. Think about the income you're earning, and then what's my after-tax yield, and make sure you're kind of maximizing it for your own situation. I think that's super, super helpful.

All right, Cooper, I want to wrap it up with one final question. We've talked a lot about the valuations, credit quality, what are munis, things like that, but let's close it with potential opportunities in the muni market today. So if I'm an investor, where could I potentially find some opportunities in the muni market?

COOPER: Yeah, so this one's actually kind of a boring takeaway. But I think average market as a whole, if you are a higher income earner, can be an attractive opportunity. Just to give numbers behind that, to illustrate as we're recording this, the municipal … the Bloomberg Municipal Bond Index has a yield of about 3.8%. For an investor who's in that top tax bracket, that's a tax equivalent yield of about 6.4%. Relative to corporate bonds, high-yield corporate bonds, for example, that have much more credit risk, we do think that that can make sense. For more tactical investors, I do think adding some credit risk, moving down the spectrum into say like A-rated issuers can be the sweet spot.

I'd be cautious about going all the way down to those BBB-rated issuers, because like we mentioned earlier, it's a very small part of the market. So you might be taking on too much liquidity risk. And then in terms of strategies, Collin, you and I could talk about this quite a bit, but I do think ladder strategies are a way to access the market or a way to consider investing. And really what a ladder strategy is, is that you invest a similar amount into incremental time periods.

So for example, you'd buy a one-year bond, a two-year bond, a three-year bond with the same amount. And the benefit there is that, generally speaking, it takes the guesswork out of timing interest rates. So if interest rates rise, you know that as bonds come due, you're buying bonds that are at higher yielding environment. If interest rates drop, well, that's not too good, but it's also a situation to where you have some longer-term bonds that you've locked in. And so you kind of take that guesswork out and it helps to minimize reinvestment risk.

COLLIN: Those are great points. I think bond ladders are really good ways for investors to consider the bond market, especially the municipal bond market. And you mentioned a boring take. That's OK. As bond guys here, bonds, I think are sometimes meant to be boring. And if I can earn what I think is an attractive after-tax yield or tax-free yield with a promise of repayment, barring default, of course, if that's boring, that's OK. I think that's a nice proposition.

COOPER: Yeah, I think that's a great one is that munis are meant to be boring. I will highlight one of the quotes that one of our colleagues always said is "Don't expect equity-like returns." And you also shouldn't expect equity like volatility, if you're investing in municipal bonds. So I think that's kind of the takeaway on it is that, yes, they are supposed to be that "Steady Eddie" portion of your portfolio.

COLLIN: And I think that's a great way to wrap up our conversation. Cooper, thank you so much for joining us.

COOPER: I'm happy to be here, Collin. Thank you very much.

LIZ ANN: All right, here we are in the episode where it's look-ahead time, Collin. So what do you think investors should be watching for next week?

COLLIN: Yeah, we get a lot of data next week. We get consumer confidence on Tuesday. We get a lot of the various Fed district bank business surveys, both for services and manufacturing. That's always good to kind of see what the business outlook looks like to kind of balance that soft data, the survey-based data, with the actual hard data. But what I'm really focused on are the PCE report and the second release.

LIZ ANN: Personal Consumption Expenditures Price Index, the Fed's preferred measure. You're very welcome, happy to help.

COLLIN: Thank you for spelling that out for me. We get the, I can say, PCE now since you spelled it out. We get that next Thursday, and it is the Fed's preferred index for now, I guess, right? Maybe that changes over time. We tend to look at core PCE, especially right now. We know that energy prices are a big influence there. So we want to see if it's flowing in to the, you know, the core readings. And it has to a degree. And so how much we see core PCE increase will be very important for our Fed outlook.

So if we go back to the March reading, on a year-over-year basis, core PCE rose by 3.2%. That was the largest year-over-year gain since November 2023. So again, moving in the wrong direction. And it's going to be very important with how that trend evolves and what that means for the Federal Reserve later this year and into 2027. And we'll also get the second look at first quarter GDP. The first release showed GDP growing by 2% annualized. Looks like expectations are for slightly higher with the second release. Looks like 2.1% right now. One thing that I always tend to focus on is personal consumption. We know the consumer is a big driver of the economy, and we're looking to see if the consumer is still holding up. So far it mostly has. And I'll be looking to see, I think it'll be more important probably in the second quarter release, but if higher gas prices are impacting discretionary spending. So for now, this is still just the first quarter, but that's something that we focus on because the consumer is a big driver of the economy. So what about you, Liz Ann?

LIZ ANN: Well, one thing to pay attention to is by the time this episode drops, we will have gotten University of Michigan's consumer sentiment reading. But as you mentioned, we're also getting, next week, consumer confidence, which comes out of the Conference Board. Those have been running, not opposite each other, but a big gap. Consumer confidence has been a bit more resilient than consumer sentiment, which is plumbing record lows.

And I just wanted to point out part of the reason for that is based on the nature of the questions that are asked. Consumer sentiment tends to be biased more by what's going on in inflation, and consumer confidence tends to be biased more by what's going on in the labor market. So just wanted to provide a little bit of that explainer for people who wonder why these two seemingly similarly labeled indicators are not the same.

You mentioned the regional Fed indexes that come out. That's survey-based data. And I find sometimes that the verbatim comments that you can pick out from companies in the regions are interesting to listen to. And then a bunch of housing data comes out next week as well with the move up in yields. That starts to be maybe something more in focus. And then we get the trade balance. And given that, at least optically, tariffs have not been on the front page, but they are still impacting things like trade, so I'll keep paying attention to that.

All right, well, that's it for us this week. Thanks, as always, for listening. As a reminder, you can keep up with us in real time on social media. I'm @LizAnnSonders on X and LinkedIn. Make sure you're following me and not one of my imposters.

COLLIN: And I'm @CollinMartinCS on X and LinkedIn. That's Collin with two L's, and the CS is for Charles Schwab.

LIZ ANN: And you can always read all of our written reports. They always have lots of charts and graphs, and they can be found at schwab.com/learn. And if you've enjoyed the show, please consider leaving us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen. And please tell a friend or more about the show, and we will be back with a new episode next week.

For important disclosures, see the show notes, or visit schwab.com/OnInvesting, where you can also find the transcript.