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I had lunch over the weekend with a fellow money manager specializing in municipal bonds. Because of the growing volume of municipal bond business, I like to gather opinions about where the best opportunities are right now in this space.

It’s no secret that the current yield spread between treasuries and municipal bonds is totally out of whack. In case you don’t know the historical norms, here is some background: Because municipal bonds purchased by state residents are often free of state and federal taxes, they typically yield less interest to investors than treasury securities with comparable maturities. Lately, treasuries yields have been abysmal in light of the recession. The ‘flight to safety’ play has treasury prices sky high and yields very low. Similarly, the highest rated municipal bonds (AAA) are paying much less interest than municipals bonds in the A and BBB space.

I asked my friend if the depressed prices of these highly graded (but not highest graded) muni bonds are accurately reflecting a serious risk of default, or if this could potentially be an opportunity for investors to get paid while the market recovers. I was told that short-medium term treasury prices are ‘unsustainably high’ and quite possibly nothing more than a hiding spot which may disappear if investor’s appetite for risk continues to climb. We also went through a variety of trading strategies which may be profitable if treasury prices continue falling and municipal bond prices (mid-spectrum) continue to rise.

We looked through several historical graphs of treasuries prices and yields, municipal bonds with AAA ratings and with BBB ratings and lower. If you chart out various muni grades from 1998-2008, they chart out similarly, with prices bouncing around within a 10% range of each other. However, starting in late 2008, the BBB grade muni bond prices fall off a cliff, creating a yield spread of over 500 basis points.* Why? The most common answer is a fear of a massive default wave over the next few years similar to that of the Great Depression. What has the actual default rate been so far in the BBB space? Under 1%, or historically average as if the recession barely exists.

The explanation for why BBB bonds could jump in price dramatically is as follows: municipalities rarely default on their bonds. When they do, it’s a dead last resort which badly tarnishes the municipality’s future ability to raise cash. Most municipalities, I’m told, would rather fire employees, freeze wages, cut services, basically use every other tool in the box before they turn their back on bondholders. Over the past two weeks many of these BBB bonds have rallied about 15% off their lows.** This has correlated with a jump in the stock market and an overall greater appetite for risk by investors. Many people believe the opportunity offered in the BBB muni bond space is unusually high right now, and the total return could rival that of the S&P 500 during recovery.

That’s not to say ultra-high grade (AAA) municipal bonds aren’t also an interesting space to be in. Prices are down somewhat from the high points (although not much because after treasuries and cash this is considered one of the safer places to hide) and plenty of people still feel the recession has legs. If that is the case, now would be ‘early’ in terms of jumping back into the lower-grade space where the default rate is still uncertain. I may be willing to get my feet wet with BBB bonds but not everybody will do the same.

Along the same lines, shorting the current price of long-term treasury bonds seems to be a popular trade. Barron's ran a cover story on this a few months back when treasury prices were even higher and the 10-year T-bond was under 3%. The 10-year is still down in the 3.2% range with some expecting it to rise back to a more ‘normal’ 5% within 24 months. If that were to happen, you’d likely see muni bond prices come up, pushing yields down closer to historical averages.

* TheStreet.com: “Take Another Look at High-Yield Munis:” Interview with John Miller of Nuveen: 02/26/2009

** Source: Bloomberg Media: Jan 1st – May 11th 2009

Source: Tax-Free Muni Bonds: Respect the Yield Curve