For municipal bond investors it is the best of times and the worst of times.

The difference is in the eye of the beholder.

Meet Mr. Smith.  He couldn’t be happier.  He has been buying municipal bonds for more than 25 years, and can’t recall a time when good quality, tax-free bonds could be purchased at what he calls “bargain basement” prices.

Meet Mr. Jones.  He isn’t pleased at all with the muni market.  Also a long-term bond investor, he has recently witnessed the downgrading of virtually every bond insurer during the current financial crisis, and is distressed over the decline in the market value of his bond holdings.

Although Mr. Smith’s portfolio has also slipped in value, he recognizes this is caused by the same market dynamics that are enabling him to purchase well secured bonds with yields ranging from 5.00% to 6.00%.

Do The Math

Mr. Smith is a long-term investor, as are most bond buyers.  He is aware that municipal bonds typically yield between 85% to 93% of comparable-maturity Treasury bonds.

With the 30-year Treasury bond yielding approximately 4.60%, his experience tells him that munis should be yielding between 4.00% and 4.50%.  At 5.00% plus, he is buying all the high-quality bonds he can get his hands on.

Ironically, Mr. Jones is also a “buy and hold” investor, but is so preoccupied by market machinations he fails to recognize the opportunities that Mr. Smith is so excited about, mainly because, according to his monthly statement, bonds he recently purchased are valued below what he paid for them.

At FMSbonds, we speak to Mr. Smith and Mr. Jones every day.  Our 30 years of buying and selling tax-free bonds tells us Mr. Smith has it right.

A tax-free bond yielding 5.25% is comparable to a taxable investment yielding 7.30%, for an investor in the 28% tax bracket, and over 8.00% for an investor in the maximum tax bracket (35%).

We don’t know a taxable investment of similar quality that can promise these returns.

No Institutional Support

The reasons munis are cheap when compared to other fixed income securities is due more to the woes of the major brokerage firms than to the follies of the bond insurers.

Municipal bond market rates are determined by supply and demand.  While the major wire houses are licking their wounds, they are lending no support (demand) to the market, causing spreads to widen between offering prices and bid prices.  Our hypothetical Mr. Smith knows this and is unfazed by the market values he sees on his monthly statement.  Mr. Jones, on the other hand, is distracted by the current prices of his holdings, which keeps him from participating in what may prove to be an historic opportunity.

Again we side with Mr. Smith.

Think Income

As every bond buyer should know, bonds are purchased for tax-free income, not for the pursuit of capital gains.  They are long-term investments that will sometimes be worth more than their cost, and sometimes less.  The key is to collect and, whenever possible, reinvest the income.  The higher yields in the marketplace today afford the bond investor an opportunity to increase the current yield on his portfolio.

One thing we know for sure is that these conditions will not last.

The large Wall Street firms will eventually recapitalize and, once again, become a significant factor in the municipal market, as will hedge funds and other institutional investors who have been forced to liquidate their municipal bonds to shore up the holes in their balance sheets.

When this support returns to the market, Mr. Jones will once again be comfortable with the value of his holdings, but will undoubtedly regret he passed on the generous yields available today.

James A. Klotz is the President of FMSbonds, Inc. Email the Author08/07/2008