Embrace the New Normal
Marilyn Cohen, Forbes Magazine, 05.20.09

Two reasons for liking municipal bonds: Their yields are better than those on Treasurys, and taxes are going up.

Institutional investors have discovered a new normal in our markets. Normality, they are saying, means sluggish economic growth, a sideways or down stock market, lower consumption, disappointing dividend returns and inflation right around the corner.

For my bond market brethren the new normal has come to mean that municipal bonds yield more than comparable Treasurys. This fait accompli began in the frenetic days when Bear Stearns imploded, then cranked up during September 2008, when the financial markets melted down.

In my 30-odd years in the market, I've seen municipal bonds outyield Treasurys for a week, maybe two, but never for as extended a period of time as they have recently. This time it actually is different. Investors are scared, and they are clinging to Treasurys like a security blanket. A five-year single-a general obligation bond from California yields 3%, while the five-year Treasury yields 2% (in both cases, these are yields to maturity).

Is it going to be a permanent feature of the bond market that munis yield more than Treasurys? I don't have a clue, but I can tell you of another new normal that you aren't going to like: higher taxes. That reality will make munis attractive even if their yields were meager. Treasurys are exempt from state income tax, most municipal bonds are exempt from federal tax, and home-state munis are (almost always) exempt from both.

California just raised its top tax rate to 10.6%. For residents of New York City the combined urban and state income tax rate (for incomes above $200,000) is 12.6%. New Jersey, Arizona, Illinois, Oregon and other states are considering increases in income taxes. Couple these high state rates with Obama's promise to let the Bush tax cuts die and you conclude that fully taxable interest (from a bank account or a corporate bond) is not much use to you.

If you reside in California or New York, you'd have to be petrified of defaults not to buy municipal bonds issued by your state. My mantra has always been that general-obligation, water and sewer municipal bonds, direct-revenue tax and toll bridge bonds are the best bets for conservative investors.

Those of you lucky enough to be living in states with low or no income taxes should consider the Texas State Transportation Commission Mobility Funds 5% issue due Apr. 1, 2017. These bonds have the full faith and credit pledge of Texas. The Mobility Fund was created in 2001 by the Texas legislature. It issues bonds whose future revenues come from multiple sources such as driver's license fees, traffic violation proceeds and motor vehicle inspection fees. Proceeds of the bond issues typically go for things like highways and state construction--tangible projects investors can easily understand.

The Texas Mobility bonds are rated AA by Standard & Poor's and mature in 2017. They are callable on Apr. 1, 2016 at par and today they are priced at 112 to yield 3.05% to call and 3.26% to maturity.

Fiscally responsible Wisconsin has general obligations rated AA with a 4.25% coupon due May 1, 2012. They are priced at 107 to yield 1.8% to maturity. Meager, but better than the 1.3% you get on a (federally taxable) U.S. Treasury due in three years. For better liquidity, you could get Vanguard's Short-Term Tax-Exempt Fund (VWSTX) with an average maturity of 1.2 years and yield of 1.5%. But if you are pretty sure of being able to hold to maturity, you're better off with a mix of munis like this Wisconsin issue.

The big risk in munis, of course, is that interest rates will rise. This would damage muni bonds (or any bonds), but I think that the higher state and federal taxes will create a floor under the prices of short- and intermediate-term munis. Long-maturity municipal bonds are a different story.

A large group of tax-weary investors reside in New York City. In my view Big Apple residents would be foolish to pass up the deals they can get in municipals today. Currently five-year Treasurys are yielding 2% and five-year corporate bonds rated AA pay 3.3%. New York City general obligation bonds such as the 4% issue due Aug. 1, 2014 are yielding 2.6%. These bonds are rated AA by Standard & Poor's and yield as much after taxes as a corporate bond yielding 4.8%. Short-term yields like these won't make you rich, but there is something to be said for having a chunk of your capital in a place where it's fairly safe.

Marilyn Cohen is president of Envision Capital Management, Inc., a Los Angeles fixed-income money manager. Visit her home page at www.forbes.com/cohen.