An Excellent Time to Buy Munis

Now is the perfect opportunity to buy municipal bonds, according to Jon Birger of Fortune Magazine:

Right now the yield on a 15-year, single-A, state of California bond is 4.5 percent, according to Bloomberg data. That's the equivalent of a 7.72 percent yield on a taxable investment for a California resident in the highest tax bracket. And before you start clucking at that single-A credit rating, ask yourself whether Warren Buffett would be getting into the bond insurance business - he launched Berkshire Hathaway Assurance Corp. in January - if it weren't a slam dunk. The historical default rate on single-A-rated munis is 0.0084 percent - 80 times lower, according to rating agency Moody's Investors Service, than the historical default rate on triple-A-rated corporate bonds.

But despite the attraction, and the tax advantages granted by muni bonds (the federal government exempts interest on muni bonds from federal income tax), there currently seems to be no mad rush for the product. Why not?

One wrench in the works could be that the insurance companies, that were insuring half of all muni issues by 2000, turned to a new line of business - the CDO - and we can all see where that landed them:

CDO-related losses have not only crushed Ambac (ABK) and MBIA's (MBI) stock prices, but they've obliterated muni investors' faith in the triple-A ratings of the municipal bonds these companies guarantee. Insured munis are now so out of favor, say analysts and bond fund managers, that some are trading at prices below that of uninsured bonds with comparable underlying ratings.

Richard Lehmann, writing in Forbes, indeed picks up on this:

Ambac's credit enhancement has already been downgraded to AA by Fitch and may lose its AAA rating with Moody's and S&P, which would effectively foreclose the writing of new business. It also means the muni bonds they insure will be rated lower, which will result in a price decline for such issues.

Lehmann also notes an upcoming Supreme Court case challenging the current tax exemptions. The effect of these woes has led to heavy selling of munis, while losing sight of the typical state or municipality's ability to raise revenues. As Birger reports, even the big Wall Street firms have taken to selling their munis to cover their massive losses on the mortgage front. The effect has spread to the municipal credit default swap market:

...prices in the swap market have gone completely haywire and now assume a preposterous 30 percent chance of default for state of California GO bonds (rated single-A) and a 25 percent likelihood of default for New York City GOs (rated double-A). "These are stupid levels," says the trader. "Nobody is really worried about the underlying credits, yet people are scared to buy muni bonds."

But as Birger sees it, this sell-off provides a buyer's opportunity, and he recommends, in particular, buying through mutual funds, Legg Mason Partners Managed Municipals (SHMMX) and Oppenheimer Rochester National Municipals (ORNAX), to name two.

See also:
Understanding Muni Bond ETFs
Municipal Bond ETFs and Closed-End Funds

Comments

[Finguy]

Good article. If one buys a muni bond and holds to maturity (and the bond does not default), then the price swings in the interim dont matter to a small investor. But how does it work if you buy a muni mutual fund? The NAV may decrease after you buy- I guess you just hold the fund for long term and hope the NAV goes back up? Do muni mutual funds sell holdings at a loss? Would appreciate some enlightenment on this. Thanks.