In stark contrast to the gloom and doom that plagued the municipal bond market a year ago, muni bonds have never looked as good as they do right now. Although there are some obvious forces driving the trend, it is nonetheless rare to see muni bonds compare so favorably with Treasuries and other taxable bonds.
Muni yields tend to skew lower, reflecting the benefits of their tax-exempt gains. The 10-year yield for a triple-A-rated muni was below 100% of the yield on the 10-year Treasury for years.
Between 2001 and 2007, for example, the average muni-to-Treasury-yield ratio was 86%.
Over the past few years, however, as Treasury yields have fallen and been artificially held down by the Federal Reserve's monetary policies, that ratio has been hovering above 100%, and on occasion even spiked to close to 200%.
In fact, the muni appeal has gotten so extreme that some professional money managers have actually started using tax-exempt muni bonds inside qualified retirement accounts.
“It's a tough argument right now, even for people really concerned about safety, to not look at muni bonds,” said J. Brent Burns, president of Asset Dedication LLC, which builds fixed-income separate accounts.
TOO GOOD TO IGNORE
This year, when he saw the muni-to-Treasury ratio on a particular muni bond reach 160%, he added the investment to a bond portfolio inside a qualified retirement account.
“It's outside-the-box thinking and it usually doesn't make sense, but who says you can't use a tax-exempt bond in a qualified account?” Mr. Burns said.
The nearly $3 trillion muni bond market, including more than 1.5 million distinct bonds, is extremely fragmented, and unlike Treasuries, there is no generic muni bond that represents the market.
But there are individual examples that are becoming difficult to ignore, according to Michael Schroeder, chief investment officer at Wasmer Schroeder & Co. Inc., a $4.2 billion asset management firm that specializes in fixed income.
He cited the recent example of a 2.19% yield on triple-A-rated, 10-year general-obligation bonds issued by the state of Georgia. Compared with the 2.06% yield on the 10-year Treasury bond, the relative yield ratio on the new Georgia muni bonds is 106%.
Considering an average muni bond yield of about 2.3%, Mr. Schroeder said that it would take a 4% yield on a comparable corporate bond to equal the net after-tax yield for an individual in the highest tax bracket.
Using data from research and consulting firm Municipal Market Advisors, Mr. Schroeder estimates that the relative value of munis has been climbing in near-direct proportion to the lower yield on Treasury bonds.
From January 2001 through October of this year, the data show that when 10-year Treasury yields were between 5% and 6%, the average muni-to-Treasury-yield ratio was 83%, he said.
But during that same period, whenever Treasury yields fell below 3%, that average ratio was 117%, Mr. Schroeder said.
The separation between muni and Treasury bond yields is partially due to the fact than muni bond investors are mostly individuals buying either directly or indirectly through mutual funds.
"FLIGHT TO QUALITY'
“Munis tend to not benefit [with higher prices and lower yields] from the flight to quality toward Treasuries,” Mr. Schroeder said. “And if and when rates start moving up again, munis also won't sell off the same way as Treasuries.”
As market volatility has driven more investors toward the safety of Treasury bonds, pushing yields lower, the typical muni investor has made no such move, because the yields aren't very attractive to individual investors motivated mostly by yield.
In addition to the flight-to-quality pressure on Treasury yields, there is also the synthetic force of a Fed policy aimed at keeping rates low.
“The separation from Treasuries does highlight munis as still being a good deal, relatively speaking, but you have to also look at where it is coming from,” Mr. Burns said. “Right now, it is clearly coming from the Treasury side; it's not because munis are yielding off the charts.”
With that in mind, Mr. Burns emphasized that “munis are a good deal relative only to other bonds, so if you're looking for bonds, this is a ratio that should be considered.”
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected]
