Published:
June 2, 2008
Municipal bonds are one of the
most compelling opportunities
emerging from the recent turmoil in
the credit markets. Municipalities, such as
counties and school districts, issue
bonds to build and repair roadways,
bridges, buildings, sewer systems,
and the like. They repay the debt
with revenues taken in from taxes
and tolls. Currently, yields for
these bonds backed by local
governments are close to historical
highs.
And these yields are exempt from
federal income taxes, making total
returns higher yet. Plus, depending
on where you live they may also be
exempt from state taxes, giving you
an added bonus.
The Same Safety at Higher Yields
For instance, you can get a 5.0%
yield on a "AA-"-rated, 30-year bond
issued by New York's Liberty
Development Corporation to finance
the rebuilding of Ground Zero.
Interest on the bond is exempt from
federal taxes, and if you live in
New York, it's also free of state
taxes.
Using a
tax-equivalent yield calculator,
we quickly see that 5.0% equates to
an 8.2% yield on a taxable bond if
you're a New York resident in the
top tax bracket. In other words,
you'd have to earn a yield of 8.2%
from a taxable investment to match
the 5.0% yield offered by these muni
bonds.
And right now, muni bonds are
experiencing a historic buying
opportunity. Typically, these bonds
feature a yield about 85% that of
Treasuries with the same maturity.
But muni bond prices have dropped,
and their yields have risen closer
to parity with T-bills. While
considered almost as safe, remember
that munis also have the added
tax-advantage over Treasuries, which
boosts returns.
Historical default rates on
"A"-rated munis are less than
one-half of one percent, and even
"BBB-"-rated munis, which are in the
lowest tier of investment grade,
have a five-year default rate of
just 0.6%, according to Standard &
Poor's. In contrast, "BBB-"-rated
corporate bonds carry a five-year
default rate of 3.2%.
Too Much of a Good Thing
Munis have seen their prices fall,
and over 70% of all muni closed-end
funds are now trading at a discount to
the value of their bond portfolio. Muni prices dropped, not because of
more risk, but because of
a sudden supply increase in the
market place, driving prices down
and yields up.
During the credit crisis, investor
fears froze demand in the $330
billion short-term "auction-rate"
preferred securities market. About
75% of these short-term securities
are issued by municipalities as
tax-exempt muni debt. When the
auction-rate market stopped
functioning, it forced
municipalities to refinance their
short-term auction-rate munis as
ordinary, long-term municipal bonds,
and that boosted the supply of munis
in the bond market. Meanwhile, hedge
funds and banks looking to raise
cash to cover subprime losses dumped
truckloads of easy-to-trade munis
into the marketplace.
Fears that munis could lose their
tax-exempt status in an ongoing
Supreme Court case also fanned
investor worries. But on May 19th,
investors breathed a sigh of relief
as a Supreme Court ruling overturned
a Kentucky appeals court that
challenged the tax-exempt treatment
for in-state bonds.Attractive
For Every Tax Bracket
Now that the worst appears behind
us, the higher yields are attracting
buyers back into the muni market.
The bonds are starting to rebound,
but they're still relatively cheap.
The bottom line is that munis are
not just for investors in the
highest tax brackets. Right now,
their yields are attractive enough
that they're worth considering for
any investor, particularly those
investing with a taxable brokerage
account.
In addition, the reduced dividend
tax rates are set to expire on
December 31, 2010. Unless the
legislation is extended, all
dividend income will be taxed at the
ordinary federal income tax rate of
up to 35%, meaning tax-exempt munis
should look increasingly attractive
to income investors.
Buy Munis by the Basket
The easiest way to invest in munis
is by investing in a fund offering a
diverse basket of bonds across
issuers and maturities. In her most
recent issue of
High-Yield Investing, editor
Carla Pasternak identified a dozen
of the highest-yielding closed-end
muni funds -- including several with
taxable-equivalent yields of up to
9%.
To learn more about
High-Yield Investing, and to
learn more about these
tax-advantaged funds,
please visit this link. |
