If you’re looking for income-producing investments, don’t overlook municipal bonds. Thanks to a rarely-seen anomaly in the fixed-income markets, as of late last week, the yields on tax-free debt instruments were higher than those on Treasuries with comparable maturities- both on an absolute as well as an after-tax basis. (1)

According to Konstantine Mallas, manager of the $2.8 billion T. Rowe Price Tax-free Income fund, in his 25-years in the investment industry, “Never had I seen it happen before the credit crisis in 2008.” Since then, he says, it’s occurred more frequently. 

In most cases, the interest paid on municipal bonds is not subject to federal- and sometimes state- income tax.(2) Because of this advantage, munis can pay a lower interest rate and still be attractive on an after-tax basis to investors in higher tax brackets. 

However, turmoil in the bond markets both here and abroad, has turned the normal relationships among fixed income investments topsy-turvy, creating a window of opportunity for investors. To understand why, we need a brief math lesson. (Sorry.)

While the interest rate or “coupon” on a bond is fixed when it is issued, the price of a bond fluctuates.  This affects what’s called the “yield” of the bond, which is a way to measure the “bang-for-your-buck.” In others words, yield tells you how much of a return you get for every dollar you pay for an investment. In the case of bonds, yield is simply the annual income it pays divided by what it would cost to buy it:

Yield = Income/Interest Paid

Bond Price

Take the case of a bond with a 5% interest rate that sells for $1,000. As an investor, you would receive $50 in income a year (5% x $1,000). In this case, the yield on this bond equals its coupon rate: 5.0%. 

If the bond’s price increases to, say, $1,050, you would still receive $50 in interest. However, if you buy it at this price you’ll pay more to get the same income. Thus, the bond’s yield falls to 4.8%.

On the other hand, if the bond declines in value to $900 it would cost you less to earn the same $50 a year in income. In this example, your yield increases to 5.56%. 

As you can see, the price you have to pay to buy a particular bond directly affects its yield: The two numbers move in opposite directions.

In the past three years, several factors have depressed the prices of municipal securities, pushing yields to investors higher. It began with the crisis in the mortgage market in summer 2008, which led to the collapse of several Wall Street institutions and the multi-trillion dollar federal bailout of others. These events sparked a sell off in virtually every kind of debt except that issued by the federal government. “It’s a function of a flight to quality. Treasuries get a boost when people want a safe haven,” says Mallas.

Demand for U.S. Treasury securities sent prices skyrocketing and yields on them shrinking--in some cases, to almost zero. The reverse happened to the bonds that investors had sold: Their yields went up because their prices sank.

Since then, it seems as if every time the prices of non-Treasury bonds recover a bit, something occurs that bonks them on the head, such as Federal Reserve actions to revive the economy (QE1, QE2, Operation Twist) and new revelations in the ongoing European debt crisis. Uncertainty and concerns about the latter have unnerved investors around the world, causing a global flight to Treasuries because they are still considered the safest of all debt. 

In addition, there have been events that uniquely depressed the prices of municipal securities this year. These include the expiration (on Dec. 31 2010) of a temporary class of federally-subsidized (but taxable) municipal debt instruments called Build America Bonds. The thinking was that when states and local governments reverted to raising money the old-fashioned way, i.e. with traditional, tax-free munis, this would flood the market. Then there was prominent Wall Street analyst Meredith Whitney who foretold of massive defaults by bloated state and local municipalities, giving already-jittery investors yet another reason to remain on the sidelines.

Neither prediction has materialized. In fact, new issuance of municipal securities is down sharply this year. Mallas estimates it will amount to about $300 billion- less than the average seen in the past 10 years and far less than the $500 billion issued in 2010. 

With that said, there have been cases where municipal bond issuers defaulted- Harrisburgh, Penn., and Jefferson County, Ala., for example. But Mallas sees these more as isolated instances as opposed to part of a nationwide trend. He points out that in each case the problems were unique to the issuer and a decade in the making. In other words, they were neither a surprise nor tied to current economic or financial conditions. 

Regardless of the reasons, the upshot is that global demand for Treasury-issued securities has pushed their prices extremely high while lower demand for municipal debt has prices low. As a result of this one-two punch, the historic relationship between these two fixed income categories is drastically out of alignment. And that has created a tremendous opportunity.

Just what are we talking about in terms of the muni yield advantage? According to Mallas, who is also a manager on four other T. Rowe Price municipal funds, as of last Thursday’s close, municipal securities “are very, very cheap across the yield curve.” Translation: Whether you’re investing in munis with a two-year maturity or those set to mature 30 years from now, the yield you can get is extremely attractive compared to similar-maturity Treasuries. 

To put this into perspective, Mallas says that twenty to twenty-five years ago the yields on municipal securities were 80-to-90% of what you’d get from a Treasury of equal maturity. (Again, municipal issuers could offer lower rates because of the tax advantages these bonds receive.) But during the past decade, “the ratio hovered between 90-100%.”  

As of last Thursday’s close, municipal securities of all maturities were actually yielding more than comparable Treasuries, which is a virtually unheard of phenomenon. For example, in the 30-year category, according to Mallas, the yield on AAA-rated munis was 3.79% compared to 2.99% on Treasuries. In other words, tax-free bonds were paying 127% of the yield you’d get on taxable Treasury bonds, a situation Mallas describes in one word: “unbelievable.”

While the yield advantage of munis over Treasuries is greatest at the shortest maturities, with two-year municipals yielding 158% of Treasuries, Mallas cautions that “you have to take into account that yields [in general] are very, very low.” That is, 158% of next to nothing isn’t much to get excited about. “The ratios are cheaper at the front end, but the yields aren’t that compelling.” 

On the other hand, 30-year munis are yielding 3.79%. That’s not only an attractive yield in this environment, it is also 127% more than long-term Treasury bonds.  According to Mallas, “When you look at absolute yields, real value is out on the curve in the 10-to-30 year range. And especially the 25-to-30 year range.”

But to fully appreciate the compelling value municipal bonds offer right now, you need to compare them to Treasuries on an after-tax basis. For example, if you’re in the highest income tax bracket of 35%, a AAA municipal bond yielding 3.79% is the equivalent of earning 5.83% on a Treasury bond. 

Good luck finding one of those.

1. All data in this column is as of the close of business on 11/17/2011.

2. The exception are so-called “Build America Bonds,” a.k.a. “BABs,” where the interest payments are subsidized by the federal government. Interest on BABs is taxable to investors. These bonds are no longer being issued

 

Ms. Buckner is a Retirement and Financial Planning Specialist and an instructor in Franklin Templeton Investments' global Academy. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.

Ms. Buckner is a Retirement and Financial Planning Specialist and an instructor in Franklin Templeton Investments' global Academy. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.