Tax-Free Munis: Respect the Yield Curve

I had lunch over the weekend with a fellow money manager specializing in municipal bonds. Because of the growing volume of municipal bond business, I like to gather opinions about where the best opportunities are right now in this space. It’s no secret that the current yield spread between treasuries and municipal bonds is totally out of whack. In case you don’t know the historical norms, here is some background: Because municipal bonds purchased by state residents are often free of state and federal taxes, they typically yield less interest to investors than treasury securities with comparable maturities. Lately, treasuries yields have been abysmal in light of the recession. The ‘flight to safety’ play has treasury prices sky high and yields very low. Similarly, the highest rated municipal bonds (AAA) are paying much less interest than municipals bonds in the A and BBB space. I asked my friend if the depressed prices of these highly graded (but not highest graded) muni bonds are accurately reflecting a serious risk of default, or if this could potentially be an opportunity for investors to get paid while the market recovers. I was told that short-medium term treasury prices are ‘unsustainably high’ and quite possibly nothing more than a hiding spot which may disappear if investor’s appetite for risk continues to climb. We also went through a variety of trading strategies which may be profitable if treasury prices continue falling and municipal bond prices (mid-spectrum) continue to rise.

We looked through several historical graphs of treasuries prices and yields, municipal bonds with AAA ratings and with BBB ratings and lower. If you chart out various muni grades from 1998-2008, they chart out similarly, with prices bouncing around within a 10% range of each other. However, starting in late 2008, the BBB grade muni bond prices fall off a cliff, creating a yield spread of over 500 basis points.* Why? The most common answer is a fear of a massive default wave over the next few years similar to that of the Great Depression. What has the actual default rate been so far in the BBB space? Under 1%, or historically average as if the recession barely exists. The explanation for why BBB bonds could jump in price dramatically is as follows: municipalities rarely default on their bonds. When they do, it’s a dead last resort which badly tarnishes the municipality’s future ability to raise cash. Most municipalities, I’m told, would rather fire employees, freeze wages, cut services, basically use every other tool in the box before they turn their back on bondholders. Over the past two weeks many of these BBB bonds have rallied about 15% off their lows.** This has correlated with a jump in the stock market and an overall greater appetite for risk by investors. Many people believe the opportunity offered in the BBB muni bond space is unusually high right now, and the total return could rival that of the S&P 500 during recovery.
That’s not to say ultra-high grade (AAA) municipal bonds aren’t also an interesting space to be in. Prices are down somewhat from the high points (although not much because after treasuries and cash this is considered one of the safer places to hide) and plenty of people still feel the recession has legs. If that is the case, now would be ‘early’ in terms of jumping back into the lower-grade space where the default rate is still uncertain. I may be willing to get my feet wet with BBB bonds but not everybody will do the same.
Along the same lines, shorting the current price of long-term treasury bonds seems to be a popular trade. Barons ran a cover story on this a few months back when treasury prices were even higher and the 10-year T-bond was under 3%. The 10-year is still down in the 3.2% range with some expecting it to rise back to a more ‘normal’ 5% within 24 months. If that were to happen, you’d likely see muni bond prices come up, pushing yields down closer to historical averages.
Question or comments? E-mail me.
Russell Bailyn

Wealth Manager
Premier Financial Advisors, Inc
14 E 60th Street, #402
New York, NY 10022
P: 212-752-4343 *31
F: 212-752-7673
Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: FINRA/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.
* “Take Another Look at High-Yield Munis:” Interview with John Miller of Nuveen: 02/26/2009
** Source: Bloomberg Media: Jan 1st – May 11th 2009
Two of the major independent credit rating services are Moody’s and Standard & Poor’s. They research the financial health of each bond issuer (including issuers of municipal bonds) and assign ratings to the bonds being offered. A bond’s rating helps you assess that bond’s credit quality compared to other bonds. Moody’s and Standard & Poor’s append their ratings with an indicator to show a bond’s ranking within a category. Moody’s uses a numerical indicator. For example, A1 is better than A2 (but still not as good as Aa). Standard & Poor’s use a plus or minus indicator. For example, A+ is better than A, and A is better than A-. Investors typically group bond ratings into two major categories: Investment grade refers to bonds rated Baa/BBB or better. High Yield (also called speculative risk) refers to bonds rated below Baa/BBB. You need to have a high risk tolerance to invest in these bonds.
Government bonds and Treasury bills are guaranteed by the US government and, if held to maturity, they offer a fixed rate of return and fixed principal value.
Municipal bonds offer interest payments exempt from federal taxes and potentially state and local income taxes. Unlike U.S. Treasuries, municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer.
The value of bonds will fluctuate with the changes in interest rates, and if sold prior to maturity may be worth more or less than their original cost.
The S&P 500 Index is an unmanaged index that is generally considered representative of the U.S. Stock market. The performance of an unmanaged index is not indicative of the performance of any particular investment. Individuals cannot invest directly in an index. Past performance is never a guarantee of future results. Investments offering the potential for higher rates of return also involve a higher degree of risk. Actual results will vary.

One thought on “Tax-Free Munis: Respect the Yield Curve”

  1. I think you’re right about the perceived risk of default having some effect on the price of muni bonds. We need to remember that muni bonds are not priced off the treasury curve; they’re priced off the MMD. Usually the MMD follows the treasury curve but I’ve seen them move in opposite directions several times. It seems like muni prices hit rock bottom when Lehman’s portfolio was liquidated. I was seeing yields as high as 7% on some of the longer 0 coupon stuff that was A rated. Prices are still going up little by little, but they are still way out of whack ( below the norm ). We all know that the treasury is trying to artificially hold the 10 yr down so that 30 yr mortgage rates will go down and the people that are in trouble with their home loans can refinance. Even so, they still seem to be creeping up and I don’t think the treasury has enough money to continue buying them back at the rate that they have been. We will probably see the 10 year continue to creep up and this may put muni bonds back in line with the curve. That’s my $0.02.

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