Is It Time To Sell Out Of Longer Term Municipal Bonds?

Longer-term municipal bonds with maturities of around 15 years to 25 years looked very attractive at the beginning of the year as they yielded the same or more than comparable taxable bonds. That's rare.

Normally tax-free bonds yield less than comparable taxable bonds in nominal terms, since after tax municipal bonds look even more attractive.

In early January the absolute spreads between AAA general obligation municipal bonds and treasuries were between 0.60 percent and 0.70 percent. This means for roughly the same credit risk (very little) and the same maturity investors were paid more to buy tax-free bonds than taxable bonds.

The 30 year Treasury bond yielded about 3.9 percent, while the comparable tax free municipal yielded around 4.5 percent. After tax this yield advantage widened.

If you assume a 25 percent tax bracket for an investor, the tax equivalent yield of the municipal bond becomes approximately 5.6 percent. The 5.6 percent versus 3.9 percent tax equivalent spread represented an historically wide yield advantage in holding municipal bonds.

Long Versus Short Maturities

Does this advantage still exist, and now that interest rates have come down is it still worth taking the risk to go out that far on the curve?

Over the past eight to nine months, the spreads have compressed materially. The average difference in long dated municipal yields versus treasury bond yields decreased between 0.3 percent and 0.5 percent since the start of 2014. In addition to the spread compression, overall interest rate levels have gone down by about 0.5 percent to 0.6 percent at longer maturity bonds.

This combination has been a perfect storm (in a good way) for long muni bonds, as the asset class is up between 7 and 11 percent through July. So after this impressive run is it time to flee to the "safety" of shorter term bonds?

No question, one should be more cautious at this point while entering a long municipal bond. However, the fact that spreads have compressed and rates have decreased does not mean the investment should be avoided completely. Historically spreads are now average to still somewhat in favor of municipals versus treasuries, especially in the 20 to 30 year range.

The other danger is the level of interest rates; if they were to move up materially long dated bonds of all types would suffer (as they did in 2013). However if the Federal Reserve gradually raises the Fed Funds rate to 2 percent or so over the next couple years short term bonds would certainly be affected, but it is unclear how much that would hurt longer bonds (which are less affected by Fed moves).

Depends On The Portfolio

The other factor for all investors to consider is the allocation of their personal portfolio.

If an investor has a mostly bond portfolio and therefore is accepting a lot of interest rate risk already, buying long dated municipal bonds should be done with caution. If the investor has mostly stocks, and little overall interest rate risk (but substantial stock market risk) buying these bonds over a period of time can still be advisable.

Some ETFs offer investors easy access to long dated municipal bonds.

I-shares National AMT-Free Muni Bond ETF (NYSE:MUB) yields about 2.9 percent with an average maturity of around 15 years. PowerShares National AMT-Free Muni Bond ETF (NYSE:PZA) sports a 4.2 percentage yield with an average maturity of about 20 years. Finally, PowerShares Build America Bond ETF (NYSE:BAB) has a 4.1 percent yield and an average maturity of about 20 years. BAB is made up of taxable municipal bonds so this ETF should usually be purchased within IRAs.

As a comparison, the I-shares 20+ Treasury Bond ETF (NYSE:TLT) which has an average maturity north of 20 years and is taxable yields only 3 percent.

Eric Mancini is the Director of Investment Research at Traphagen Financial Group (www.tfgllc.com), which is located in northern New Jersey. Traphagen Financial Group has been trimming the longer dated municipal bonds for some clients in recent months, but we have not exited the position en mass.