Tax-Free Muni Bond Yields Now Above Taxable Treasury Yields
Kurt Brouwer January 25th, 2008
This is not something you see very often. Typically, municipal bonds and bond funds yield less than taxable bonds and bond funds. Why? Because most muni bonds are tax-free for Federal income tax purposes. Now, we see yields on many municipal bonds have actually crept up higher than taxable bonds yields. It is doubtful that this will last too long, but it is a good time to be a buyer of municipal bond funds in my opinion. In this piece, with its tongue-in-cheek title, John Waggoner spells it out [emphasis added]:
Municipal bonds become ‘a great value’ (USA Today, January 25, 2008, John Waggoner)
Painful as the credit crisis has been to many people, it’s become a boon to at least one group: municipal bond investors.Muni bonds - issued by states, cities and municipal authorities - offer interest that’s free from federal income tax and sometimes from state and local taxes, too. Normally, muni yields are lower than Treasury bond yields and so make a smart investment mainly for people in a high tax bracket.
But munis are now yielding more than Treasury bonds, making them attractive even if you pay no federal taxes. It’s something that’s happened just twice - and briefly - since 1990.
“Munis are a great value,” notes Dave MacEwen, chief investment officer for fixed income at American Century Investments.
And when you factor in the effect of federal taxes, the muni is even more attractive. Say you’re in the 25% tax bracket. You’d need that 2.84% five-year T-note to yield 4.21% to earn the equivalent of the muni’s 3.16% after federal taxes…
…The troubles of two municipal bond insurers — Ambac and MBIA — have also helped keep muni bond yields high. Muni bond issuers buy default insurance to try to get higher credit ratings and lower yields for their bonds. Investors demand higher yields from issuers when they detect a higher risk of default.
Muni bond insurers have also been clobbered by losses from their investments in mortgage-backed securities. Last week, Ambac fired its CEO, cut its dividend and said it expected a net loss per share of up to $32.83 for the fourth quarter of 2007. Fitch Ratings cut Ambac’s financial strength rating on Friday.
But municipal defaults are rare. Only about 0.3% of investment-grade munis default each year, compared with 2.1% of investment-grade corporate bonds, says American Century’s McEwen. Many insured munis have seen their yields rise to the levels they would be if they had no insurance at all, McEwen says.
Example: A five-year, top-rated muni bond yields 3.16%, according to Bloomberg. That compares with 2.84% for a five-year T-note.
In addition to the reasons cited above, muni bonds have been under selling pressure because many institutions such as banks, insurance companies and even hedge funds have been dumping them. With the need to raise additional cash, those holders of munis had to sell and that depressed prices. As a result, last year was the worst yield for muni bond performance since 1999 (see Bad Year For Muni Bonds).
- Investing , Mutual Funds , Personal Finance
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Aren’t muni bonds the great, stable deal they are because it is extremely difficult for a taxing authority to declare official default? I’ve seen the Chapter 9 bankruptcy process, and the layers one has to go through are astounding.
That’s correct Brad. Municipalities are taxing authorities for the most part. There are some revenue bonds tied to specific projects of course, but most munis are backed by the power to tax. Municipal bond defaults are very rare.