That holds true for the relationship between 10-year Treasury yields and yields on AAA-rated 10-year municipal bonds. Due to municipal bonds’ tax-exempt treatment, yields on municipals are usually lower than those offered on taxable treasuries. But the economic recession, strong foreign demand and institutional purchases of 10-year Treasury notes has pushed that instrument’s yield to 2.5%, a 50-year low. Yields on municipal securities have moved in the opposite direction as institutions were forced to sell. Currently the yield on a 10-year, AAA-rated municipal is 4.6%, offering an attractive premium over its taxable counterpart.
Tax Treatment
U.S. Treasuries are backed by the full faith and credit of the U.S. government, offering preservation of capital, but are subject to federal income tax. Municipals, not subject to federal income taxes, offer preservation of capital and tax-exempt income. Municipals also offer a chance to perform a civic duty for a good rate of return. Bridges, public transportation, water and sewer projects, airports and schools are all examples of public projects funded by municipal bonds.
Types of Municipal Bonds
As with Treasuries, municipal bonds afford no ownership, but a promise of interest payments for the duration of the loan and, upon maturity, repayment of principal. Municipals that are the safest are pre-funded, backed by an escrow account of U.S. treasuries. General obligation municipals are backed by tax receipts, while revenue anticipation municipals are backed by a source of revenue. It’s important to know the source and reliability of the revenue stream.
Risks
Municipals are subject to interest rate and credit risks. If rates rise, prices of municipal bonds fall, the same as treasuries. Credit risk is a function of the issuing municipality. Standard and Poor’s, Moody’s and Fitch are the agencies that assign risk ratings to municipals. AAA-rating is the safest, under BBB is considered risky or junk. According to S&P, the average default rate on municipals is 0.06% compared to corporate bond default rate of 3.2%
Opportunity
President-elect Obama has stated his desire to create jobs with a massive infrastructure effort to build and repair highways, bridges, along with water and sewer systems. The nation’s Governors have already requested $176 billion in bailout funds to assist in rebuilding. Until the credit market thaws, municipals will continue to yield more than treasuries, offering a benefit to those high tax-bracket investors and others looking for tax free income.
What to Look For
First, calculate the tax equivalent yield of the municipal by dividing the interest rate by 1 minus the tax rate. For an investor in the 28% tax bracket, the tax-equivalent yield for a current 10-year, AAA municipal would be the current yield, 4.6% divided by .72, or 6.7%. That’s what a 10-year Treasury note would have to yield to compete for investor dollars. Current 10-year treasury yields are much lower, hence the investment opportunity.
Next, check the credit rating assigned to the municipal and determine the level of risk. Invest in mature municipalities instead of planned communities. Some of those planned communities may not come to fruition, especially in light of the housing market.
Finally, decide whether to invest in individual bond issues or a low-cost, no-load mutual fund. Mutual funds offer professional management, liquidity and diversification for the not-so-rich investor.
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