Muni yields aren't puny

Commentary: High-quality tax-exempt bonds are trading at bargain prices

By Alexander Anderson, Jr. April 7, 2008

LOS ANGELES (MarketWatch) -- The gyrations jarring the capital markets have caused many investors to question just where they can invest their money safely, yet still earn a decent rate of return. Municipal bonds are a good place to look.

Stocks remain attractive for long-term investors, but the recent swings in the Dow Jones Industrial Average ($INDU) have been unnerving. Treasurys are always a safe haven, but their yields have dropped significantly in recent months, to the point where they're no longer attractive (around 3.5% for a 10-year Treasury). The possibility of recession is negative for the corporate bond market, and the mortgage/asset backed markets remain hyper-toxic and should be avoided

So where do bond investors put their money?

Tax-exempt municipal bonds offer attractive returns with a large margin of safety, and these state and local obligations should be seriously considered -- even if you're not in a higher income-tax bracket.

Of course, the municipal-bond market has been hit hard by the current credit crisis. The market was rocked by the deterioration in credit quality of the major municipal-bond insurers. The insurers' plight was self-induced -- a few years ago they diversified away from just insuring municipal debt and started to insure mortgage bonds, including many of those now-poisoned subprime types.

As a result, the insurers' credit ratings have deteriorated, and dragged down many municipal-bond prices in the process. In addition, the general weakening of the U.S. economy has slowed municipal tax receipts. As a result, more than half of all states now face budget deficits, some of them quite sizable, such as in California, where the revenue versus spending shortfall tops $14 billion.

State of the states

The flip side of these credit issues is that municipal yields have risen relative to Treasurys, to the point where tax exempts appear to be a screaming buy. For example, this time last year, AA-rated General Obligations traded at 82% of the yield of a five-year Treasury. Today, that same AA-rated municipal trades at 116% of the corresponding Treasury. Compared to Treasurys, municipal-bond yields right now are historically rare.

Adding to the appeal of municipals is their tax-free status. Most likely, this attraction is only going to increase. The tax cuts of 2001 are scheduled to expire in 2010, and regardless of whom the next president will be it seems certain that tax rates in 2011 and beyond will be significantly higher than they are now. This will boost investor demand for municipals.

As with all investments, be selective about the tax-exempt bonds you add to a portfolio. Credit quality is paramount. You want not only a good credit rating, but also bonds whose borrowers have access to a broad base of recurring revenues. State General Obligations are preferable, because such bonds are secured by the full faith and credit of the state, with a first call on state taxation proceeds.

Other bonds that are very safe are pre-refunded issues, where funds for bond repayment are held in a trustee controlled escrow account and consist of Treasury issues.

In contrast, be careful about purchasing bonds that are rated highly solely because of bond insurance. The major bond insurers -- Ambac, MBIA, and FGIC -- are all under financial pressure and might suffer from further downgrades. Also, think carefully before purchasing bonds issued from small municipalities -- their revenue sources are less broad and diversified, plus small-issues are more difficult to sell on economical terms.

When purchasing bonds, ask your broker pointed questions. Even though the market is inherently safe and offers attractive current opportunity, there is still the potential for land mines. For example, the Jefferson County, Alabama Sewer District, with more than $3 billion of outstanding bonds, ran into major problems recently due to mistakes made in purchasing derivatives which were supposed to lower the District's interest costs. Be sure your broker knows the market and is dealing with you forthrightly -- if a deal sounds too good to be true, it probably is.

If doing credit research isn't your cup of tea, then leave it to the experts. Low-fee municipal-bond funds are an economical and easy way to invest in tax exempts. Most municipal funds focus on steady income and capital preservation. Plus, the fund managers do all the credit work and you gain the benefits of diversification.

Here is a winning fund to consider: Vanguard Intermediate-Term Tax-Exempt Fund (VWITX). This low-expense fund owns high-quality bonds while earning strong returns and yielding 4.14%. It requires a $3,000 minimum investment.

If you have more money to invest, consider building a portfolio of individual bonds. One recommendation: New York City General Obligation 5.25 12/01/09 (Cusip: 64966A3T0). This short-term bond is high-quality (Rated Moody's Aa3). It is currently offered at a 2.53% yield which is a taxable-equivalent yield of 3.90% in the 35% tax bracket. This bond yields much more than a similar high-quality bank CD.

On a longer-term basis, check out Pasadena, Calif. General Obligation 4.25 11/01/15 (Cusip: 702282GT5): This highly rated (Moody's AAA, and pre-refunded) seven year-plus bond is offered around 3.30%, which equates to a 5.09% taxable-equivalent yield (again, for the 35% tax bracket).
Both of these bonds are like buying a tax-free government security -- except with a much higher yield.

Alexander Anderson, Jr. is a portfolio manager at Envision Capital Management, a Los Angeles based investment management firm.

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