I have long eschewed municipal bonds, finding that the tax-exempt benefits were not persuasive when compared to investment-grade corporates. But present conditions are changing my view.
We now have an economy bereft of conviction. It's a statistical mixed bag. The Conference Board's index of leading indicators for February was 22% higher than a year earlier. But gross domestic product slowed to an annual rate of 2.2% in the fourth quarter of 2014. Consumer spending was up 3.21% in January, but that's done little to boost the inflation rate, which came in at a big goose egg - 0% - in February. The Federal Reserve's desired rate is 2%.
And on April 3, the Labor Department reported that non-farm job creation slowed to a seasonally adjusted 126,000 in March, meaning that job growth averaged just 197,000 per month in the first quarter, compared to 324,000 per month in the fourth quarter of 2014.
The only thing certain about this economy is that it is decidedly iffy, notwithstanding the Fed's extraordinary, years-long, monetary engineering.
As a full recovery persists in failing to materialize, one's confidence wanes that it will occur before we take a step in the other direction. Deflation and a financial shock from oil's collapse are just two of numerous lingering hazards. Or we may just idle interminably.
Thus have income investors - yes, we still do exist - reached yet another decision point. (Remember when such decisions were as simple as mechanically renewing a CD or buying the next Treasury issue? Those days are gone.) With such uncertainty about the economy's direction, bond quality has risen to the fore. Hence, municipal bonds are taking on fresh appeal.
My bias now is to favor quality over mid-to-lower investment-grade bonds. And following that stricture, general obligation (G.O.), tax-free issues - bought with the intention of being held to maturity - are the bonds of choice at this time. (Rising interest rates will reduce principal value in the interim, so hold them to maturity.) The taxing authority and insurance that often accompany G.O. municipals make them a superior pick at a time when private-sector prospects, because of economic vagaries, are uncertain.
And the after-tax returns are better, too. For example:
A five-year, 3% coupon, Harris County, Texas municipal issue (CUSIP: 414214RK4, rated AA) due on April 1, 2020, bought at 105.93, has a taxable equivalent yield (TEY) of 2.88% for a person in the highest federal tax bracket, which is 39.6%. For a person in the 25% bracket, the TEY is 2.32%.
Alternatively, you could buy the Waterbury, Conn. 4.5s, also due on April 1, 2020 (CUSIP: 941247H92, rated A1). If bought at the recent price of 113.87, they would produce a TEY of 2.63% for the highest federal taxpayer and 2.12% for a 25%-bracket taxpayer.
Compare these muni TEYs to the yields of two high-quality corporates due on the same date: the 1.99% yield to maturity (YTM) for the Federal Realty Investment Trust 5.09s (CUSIP: 313747AR8, rated A-) bought at 118; or the 1.62% YTM for the Florida Power Corp. (now Duke Energy Florida) 4.55s (CUSIP: 341099CM9, rated A), bought at 113.6.
High-grade municipals also win over a longer term. The Elizabeth, N.J. 3.0s due April 1, 2024 (CUSIP: 286678AL1, rated AA3) have a TEY of 3.84% for the highest federal taxpayers and 3.09% for 25%-bracket investors. Or one could buy the New Britain, Conn. 4.5s due on the same date (CUSIP: 642713V65) at a recent price of 122.1 for a TEY of 3.01% and 2.43% in the aforementioned tax brackets.
As in the prior instance, these two muni issues beat two highly-rated corporates maturing on the same date of April 1, 2024: For the Eaton Corp. 7.625s (CUSIP: 278058AP7, rated A-), bought at 136.4, the YTM is 2.86%, and for the MasterCard 3.375s (CUSIP: 57636QAB0, rated A), bought at 107.3, the YTM is 2.37%.
Bear in mind that these corporate bond yields account for the 3.8% Obamacare tax on investment income, which is not levied upon municipal bonds. And, of course, if you live in the state of issuance, most states don't impose a state income tax your muni interest.
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