Why It's Time for Muni Bonds 19 comments
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It’s time to consider muni bonds.
Municipal bonds, or muni bonds as they’re commonly called, are issued by state, city or local governments to raise capital for public projects like building a highway, sewer, or what have you. The income produced by these utilities is then used to pay out the interest payments to investors.
However, unlike US Treasuries, muni bonds aren’t backed by the Federal government. Because of this, their yields are tax-free — meaning there’s no Federal or State income tax on their payouts. So you can pick up 5%, 6%, even 7% a year without paying a dime in taxes.
And don’t let the lack of federal backing worry you. Muni bonds are extremely safe.
Of the 400,000 muni bonds issued since 1940, only 0.5% have defaulted. That’s one fourth the default rate of corporate bonds — bonds issued by US corporations. Put another way, muni bond are four times less likely to default than their corporate counterparts.
In addition, muni bonds have outperformed both Treasuries and corporate bonds over the last ten years. A $10,000 investment in muni bonds in 1995 would be worth nearly $20,000 today. That’s roughly a 9% average annual return — the average rate of return for stocks … in tax-free bonds!
Which brings us to today.
Because of the ongoing financial crisis, Treasuries — taxed bonds — currently yield between 1.6% and 3.4%. In contrast, muni bonds — bonds that are untaxed — yield 5-6%. This discrepancy is unusual, to say the least. Why would anyone want a 3.4% yield that’s taxed when you can get a 5% yield tax-free?
Here’s how Mark McCray, head of muni bond trading at PIMCO, puts it.
Imagine that munis are attached to the Treasury market by a rubber band. Sometimes, the taxable market will walk along nice and slowly in one direction and munis will follow along virtually in lock-step. Other times, the taxable market will sprint in a certain direction and munis will just stand in place and the rubber band stretches … eventually the rubber band pulls the relationship back together. And the reason the rubber band pulls the markets back together is that, at the end of the day, municipals are still tax exempt.
Right now muni bonds are yielding nearly 150% of Treasuries — 5% vs 3.4%. As McCray would put it, the “rubber band” is extremely stretched. This won’t last. Muni and treasury yields will eventually return to their historical relationship. It’s only a matter of time. And it will happen one of two ways.
- U.S Treasuries fall, raising their yields to be more in line with muni bonds.
- Muni bonds rally, lowering their yields to be more in line with Treasuries.
I can’t tell you which one of these situations will unfold. But it seems highly likely we’ll see a bit of both. Treasuries have rallied dramatically in the last year as investors seek safety above all else. This trend won’t last however, especially in light of the regulators’ bailout bonanza. Below is a brief list of the recent policies/ bailouts enacted or proposed by the regulators:
- Paulson’s proposal to buy mortgage-related assets: $700 billion ?
- US Treasury offering to insure money market funds: $50 billion
- Bear Stearns deal: $30 billion
- AIG deal: $85 billion
- Fed’s temporary credit lines with central banks: $180bn
None of these are dollar / Treasuries positive. I’m not saying that the US will default or lose its AAA credit rating. But with US regulators making move after move that is dollar negative, Treasuries aren’t looking as risk-free as they used to.
At some point, investors will not perceive US Treasuries as the ultimate safe haven. When they do, they’ll start looking for other safe income plays. Muni bonds will be near the top of the list. Their default rate is extremely low. And they pay out cold hard cash, tax free, on a monthly basis.
Few investments offer that kind of security.
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This article has 19 comments:
Bond traders realize this and this risk is why munis are yielding at a premium. As to whether the higher yields are worth the risk? That is a more complicated question, but it certainly isn't a clear-cut as you make it out to be.
Time to take a math class...that would be 6.95% assuming twelve years.
By buying smaller school districts you are also staying away from larger issuers that have been implementing swaps and derivatives that are coming back to burn them (eg Orange Co CA in the 90s and Jefferson AL today)
As far as imminent defaults per RJK's post, I agree that's an issue that should be addressed. However, Gen. Obl. and Essential Purpose Revenue bonds (ie Water/Sewer) are as safe as they get -- it's hardly a stretch to say that they never default. and if they do, they are usually eligible for aid to keep the cashflows coming while they righten themselves... a municipality can't just declare bankruptcy and close shop like a company can... they need the market for future borrowing so they will act accordingly.
investinginbonds.com answers a lot of questions.
Is he insane? If people have doubt about the safety of the US Govt, why will they invest in munis, issued by state and local govts. They will invest in other countries or in gold.
seekingalpha.com/artic...
Your made a correlation that the US Gov't debt may become less save, and therefore, we should go buy more Muni state debt? I don't find that relationship make sense. If the US, as a country, has trouble in its debt issue, you wouldn't want to buy the munis too..... Think of it as a tree. If the tree's trunk has problem, ultimately it will affect the branches.
Let me get this straight. You actually point out that there are USD negatives to think about and from that you conclude that you need to be buying USD denominated munis? As alternative to treasuries???
Let me give you an analogy.
Suppose I had some cash. Some $100 bills. I heard that USD might go down so i started looking for alternatives and bought . . . treasuries!
Does that make sense? HELL NO!
There is a reason treasuries are trading higher than munis at the moment. And you need to understand this reason before investing into them and/or suggesting it to other people.
I'm not saying munis are good or bad a purchase right now, that would depends on your objective.
Your article has been one of those "you can't be serious" moments for me tonight :)
Tom B for an investor you have good economic insight.
DaveW Fidelity let's you buy muni's from their Secondary inventory and it it quite extensive. I think Schwab has the same thing. There has been some fascinating stuff on Fidelity on the Corporate side. 6 weeks ago Fidelity was offering Lehman bonds with a 20% yield. Today you could buy Morgan Stanley bonds for a 20% yield. ... Flash
California is a financial disaster; default or junk bond rates is entirely thinkable. It is entirely possible that munis will prove to be a whole lot less safe than they are reputed to be. And don't forget that declining dollar. 6% is not so nice if your tied-up dollars are losing more than that in purchasing power.
Thinly traded closed-ends of the thinly traded muni market are probably sporting some huge yields and discounts now, but I haven't checked that out yet since I'm not buying until there is some stability. That is a good place to look if you have money you can afford to lose.
Only thing I can add to the comments above about risks is that for most one of the benefits of munis especially if you are in high tax state is to purchase munis or a fund that is specific to your state. But this violates one of the basic principles of investment which is to diversify. If you are confident in the forecasting the economic prospects of your own state then such concentration might be warranted, but for me it is not worth it. I will take somewhat of a hit on spreads and transaction costs for selling and purchasing other bonds but I will be happy to do that. By the way I live in Oregon.
That's what this article is about. Has nothing to do with muni's.
Muni money markets are sporting 5%+ SEC 7 day yields, which is enough for me in this environment.