An Opportunity in Municipal Bonds

We all know that 2008 has been a rough year for virtually all investors, and the municipal market has not been immune. Municipals, however, have weathered the storm better than most asset classes.

Over the long term, municipals have “provided strong taxable-equivalent returns with lower volatility relative to their taxable counterparts,” according to Barclays Capital. The chart below shows the relative risk and after-tax performance of major equity and fixed income asset classes.

Tax-exempt municipals (marked as “TE Muni” on the chart) have provided higher levels of after-tax returns than Treasuries or corporate bonds over the past 10 years, and these returns have come with lower volatility, as measured by annual standard deviation of returns.

The current market environment has witnessed numerous market dislocations that have led to extreme moves due to fear and greed. These dislocations produce both opportunities and threats, but now a significant opportunity appears to be at hand for municipals.

The chart below shows the historical relationship between the 10-year Treasury and high-quality municipal bonds of the same duration. Since 1991, 10-year municipals have traded within a range of 70 percent to 100 percent of the equivalent Treasury, with the average around 83 percent. Historically, the lower yield of municipals compared to Treasuries is due to credit quality characteristics and federal income tax exemption.

Ten-year municipals are currently trading at roughly double the yields that can be found in 10-year Treasuries, and this is occurring in a safety-minded market in which they would normally trade at a discount.

As of last Friday, 10-year municipals were yielding 4.27 percent, compared to 2.13 percent for the equivalent Treasury. On a tax-equivalent basis, the municipal yield is comparable to a taxable bond yield of 6.57 percent for investors in the highest tax bracket.

We have witnessed many firsts over the past year, and this appears to be yet another one. For those who appreciate history and understand the current market dynamics, this unusual situation could represent an investment opportunity worth considering.

Comments

[Rob Viglione:]

The concern here is that 2009 will likely usher in a period of unprecedented municipal bankruptcies. Sure, the federal government will likely step in and bail out the most reckless local and state governments, but this is a fundamentally weak area in our economy. If you are bettering on munis, at least do so understanding that we are about to experience a wave of defaults.

At some point, yields make this risk worthwhile. I'm not sure what that number is, though.

2008 Dec 30 12:03 PM

[CWest:]

Look at NIF (CEMF) . Note: Insured Muni. Key word insured.

2008 Dec 30 10:30 PM

[JohnB:]

On Dec 30 10:30 PM CWest wrote:

> Look at NIF (CEMF) . Note: Insured Muni. Key word insured.
>

Insured by whom? I'm suspicious of the health of insurers, at least those who don't own the printing presses.

2008 Dec 31 12:03 PM

[bigmoney:]

In a muni bond fund, such as MUB, many of the top holdings are big cities. Are they too big to fail? What happens if they default? Will the Feds bail them out? Alot of muni's have been collecting record property taxes for years, because of the housing boom, and their budgets doubled or tripled. I don't know where the money goes, because its hard to say that services are significantly better than a decade ago.

2008 Dec 31 12:18 PM

[philq:]

4.27% on a 10-year?
The closed-end Nuveen muni funds NAD, NZF, NQS and NXZ (which I own), have been beaten down to a point that they yield 8% tax free, sell at discounts to NAV, and have average durations of about 7 years.
I'm gonna hold em---even though they're a bit dangerous.

Jan 01 11:41 AM