BondsOnline Advisor

Tax Free Municipals: A Remaining Sweet Spot

by Stephen Taub

Editor's Note: see Composite Bond Yields in BondsOnline for today's spreads and values.

The next loud noise you hear just may be the door slamming after the last investor leaves the bond market.

A strong economy, surging energy prices, the prospect for a prolonged period of rising rates, and the Fed's threat to boost them in larger clumps than many had expected have spooked all but the hardened investor, or those that haven't been paying attention.

And who can blame them? After all, the bond market is coming off a more-than two-decade run-up, culminating with the lowest rates in a couple of generations.

Yet, with this backdrop, at least one major investment banking firm is recommending that its clients actually boost their fixed-income exposure.

On Monday, June 14, Banc of America Securities strategist Thomas McManus recommended that clients lighten their equity load by 5 percent, to 60 percent, and put that dough into bonds.

"We have been massively underweighting the bond market (his last reduction was in February with the 10-year Treasury yielding around 4 percent compared to 4.85 percent today) and the negatives are well understood," he wrote in a report. "While we remain underweight, the odds are rising that the market is overestimating the pace of Federal Reserve tightening."

And, sure enough, the following day he appeared quite prescient, as surging Benchmark U.S. Treasurys sent yields of the 10-year note to their biggest drop since the market reopened after the September 11, 2001 terrorist attacks. Investors apparently were celebrating the fact that the core inflation rate met consensus estimates.

McManus in general believes the Fed must go slowly or risk damaging a still-fragile recovery. "If we are wrong and the Fed attacks inflation without much regard for a slowdown, then we might soon be moving faster to buy bonds and sell stocks," he adds.

What's more, he feels that if the economy were to slow significantly in 2004-5 with the nominal fed funds rate below 3 percent, "the ensuing easing process would result in a 1 percent fed funds rate again before too long."

So, given this view, are there any places left to invest in the bond market? Surprisingly, yes.

At least two major investment firms are still recommending tax-free municipal bonds.

Citigroup notes that some of the most dramatic progress is occurring in the 10-year maturity range. Ten year, AAA muni bond yields, which historically have averaged only about 80 percent of the yields on 10-year Treasury notes, climbed past 95 percent last year. Adjusting to a tax equivalent yield basis, assuming a 35% Federal tax rate, the 10 year muni is trading at 148 basis points over the Treasury - well above corporate bonds.
In recent weeks, however, they have been rallying as supply has declined, with the muni/Treasury yield ratio falling below 90 percent.

"There appear to be several reasons for that improvement, including a modest 'July effect,' moderate new issue volume, ongoing strong retail demand, and support by arbs/crossover buyers," it adds in a recent report.

And the folks at Pimco expect this yield benefit to continue, both on a cyclical and a secular basis. "From the cyclical perspective, consistent with our view of an improving and reflationary economy, interest rates are expected to rise," it explains. "History indicates that municipal bonds are a less volatile asset class than Treasurys, and as a result, as interest rates move higher, yields on municipal bonds will most likely move up less than yields on Treasuries."

In addition to their lower overall volatility, municipals are also heavily driven by the supply-and-demand balance. As interest rates increase, there is a good chance that new issue supply in municipal bonds will decrease because advance-refunding, in which municipalities issue new debt to replace older, higher cost debt, becomes less cost effective, Pimco explains.

In the environment of falling interest rates over the past few years, as much as 30 percent of the muni new issue market was advance-refunding issues. New supply for 2004 could therefore be as much as 25 percent to 30 percent lower than the record supply of $384 billion in 2003, Pimco recently told clients.

From the secular viewpoint, Pimco says it likes this less volatile asset class in a volatile environment. Noting that its bond guru has referred to the global economy as "walking a tightrope" between inflation and deflation over the next three to five years, Pimco adds, "in periods like this, munis, as a less volatile asset class, should be attractive."

Pimco also believes that munis appear undervalued relative to Treasurys if you look at the ratio of municipal yields to Treasury yields, both in the 10-year and the 30-year part of the curve.

Over the last 25 to 30 years, 10-year muni yield ratios have averaged between 75 percent and 80 percent of Treasury yields, mainly because munis have the advantage of tax-exempt income, according to Pimco. These days, however, they're in the range of 85-to-90 percent of Treasurys. "To the extent that we have the opportunity to buy 10-year munis at over 90 percent of Treasuries, we see very good value," it adds.

In the 30-year part of the curve, the ratio of muni yields as a percentage of Treasury yields over the last 25 to 30 years has averaged from 80 percent to 84 percent, Pimco points out. "Right now, we're able to buy 30-year munis at 93 percent to 95 percent of Treasurys and at times last year, we bought munis at close to 100 percent of Treasurys," it adds.

So from a longer-term perspective, Pimco thinks this is a very attractive proposition.
 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.