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Driven by their status as safe havens for battered international investors, a massive Federal Reserve effort to spark a sluggish economy and other factors, yields on U.S. Treasuries have dropped to levels not seen since the 1930s.
The traditional relationship between muni yields and Treasuries, in which muni yields are typically lower than Treasuries, has been turned on its head.
Now, a similar anomaly is occurring with corporate bonds.
Over the past 18 months, the corporate-over-municipal yield premium has been lower than the historical average, and has vanished altogether at times. In fact, the yield on munis has occasionally exceeded the yield on corporates of similar maturity and credit quality. It happened in late 2010 after Meredith Whitney made her headline-grabbing remarks on municipal finances, and again in late 2011 for 10-year “A”-rated bonds as well as 20-year bonds rated either “AA” or “A.”
Expanded market for munis
In the recent past, the inversion of nominal corporate and municipal bond yields has tended to be short-lived. If investors who normally buy taxable bonds—pension funds, insurance companies, and individuals investing in tax-deferred accounts—can earn a higher yield on an equivalent tax-exempt security, they have an incentive to buy municipal bonds even if they get no benefit from the tax exemption.
The quintessential feature of municipal bonds is that most are exempt from federal income tax, and, for most home-state investors, state income tax as well. When investors compare the return on municipal bonds to taxable bonds, they must adjust the yield to account for the tax benefit of municipal bonds. If the pre-tax equivalent yield on a municipal bond exceeds the yield on a taxable bond of similar credit quality and maturity, the municipal bond offers a higher after-tax return even though it has a lower nominal yield.
For an investor in the 25% federal tax bracket, the net return on a “AA”-rated municipal bond yielding 3.0% is equivalent to a “AA”-rated taxable bond yielding 4.0%. An investor in the top marginal tax bracket (35%) would have to find a “AA”-rated taxable bond yielding more than 4.6% to earn a 3.0% after tax return.
Before the 2008 financial crisis, yields on municipal bonds were usually compared to U.S. Treasury bonds. The nominal yield on munis typically fluctuated between 80% and 110% of the yield on equivalent Treasuries. Even at the low end of that range, municipal bonds still offered a higher yield than Treasuries for anyone paying federal tax at a marginal rate in excess of 20%. However, the traditional relationship broke down after 2008: municipal bonds now consistently yield more than equivalent Treasuries despite the tax exemption.
Today, when municipal bonds yield more than equivalent corporate bonds, some investors in taxable bonds will start to buy munis to pick up extra income. At $3.7 trillion, the municipal bond market is less than half the size of the $8.1 trillion U.S. corporate bond market. Taxable bond investors also buy Treasuries, government agency bonds, mortgage-backed securities and asset-backed securities, which account for another $22.5 trillion. In the aggregate, taxable bonds represent more than eight times the total amount of municipal bonds outstanding.
Given the relative size of the taxable and tax-exempt bond markets, it takes only a small shift to eliminate the municipal-over-corporate yield premium. In effect, the immense pool of money invested in taxable bonds provides a substantial backstop to municipal bonds when prices and yields get out of line.
Municipal bond investors may consider this backstop both a comfort and an opportunity. Notwithstanding massive corporate bond issuance so far this year, demand for corporate securities has been so high that yields on 10- and 20-year “A”-rated bonds are once again close to parity with the nominal yield on equivalent municipal bonds.
Experienced municipal bond investors are correct in ignoring the “sticker shock” attendant to this new lower-rate environment. They understand that although muni yields may be low by historical standards, they still represent exceptional value when compared to other fixed-income investments.
This report is produced solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. This report is based on information obtained from sources believed to be reliable but no independent verification has been made, nor is its accuracy or completeness guaranteed.