Why It's Time for Muni Bonds

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 |  Includes: MUB, PZA
by: Graham Summers

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.