Munis: Better Than Treasuries?
Tax-free bonds offer some nifty bargains.

here's a lot of fear at the moment that cities and states will default on their debts. The panic has left the municipal bond market in shambles. It's full of opportunities, too.

That's because, in some corners of the market, yields spreads have been turned on their heads. In a rare twist, some tax-free munis are offering the same or better yields as taxable Treasuries of the same maturity and, in some cases, with little or no greater risk.

If you're holding U.S. government bonds right now, you're painfully aware of the stingy yields. T-bills that mature in a year or less are paying 0.5% (annualized). The five- and 10-year Treasuries pay a mere 1.8% and 2.9%, respectively.

AAA-rated muni bond maturing in five years is yielding around 1.8% now, which is about the same as five-year Treasury bonds. But with the munis, that's a taxable equivalent yield of 2.6% for investors in the 30% tax bracket.

People who've spent a lifetime dipping in and out of the muni market are giddy. That's especially so for money men like Chicago investment advisor Mitchell A. Kovitz. He and his firm's bond trader, Richard Salerno, have been buying lots of muni bonds for their high-net-worth clients. Their firm, Kovitz Investment Management, manages $1.1 billion in assets, with $480 million of that invested in fixed-income securities.

"Before the market blew up late last year, I'd only seen munis yielding more than Treasuries on a couple of days in my career," says Kovitz, whose Chicago firm Kovitz Investment Management handles $1.1 billion in assets, including $480 million in bonds. "This has been going for weeks and weeks now."

One of the best deals going for the skittish may be so-called pre-refunded munis. The name comes from the fact that when a municipal bond issuer decides to retire old debt early, it doesn't just mail out checks. It buys special Treasury bonds called "Slugs," which stands for "state and local government series." The issuers then direct the interest and principal on these bonds to the previous holders of the relevant muni bonds. Bottom line, pre-re muni bonds are backed by the U.S. Treasury--and are tax-free to boot.

Given this generous tax treatment, pre-re muni yields are usually significantly below those on equivalent Treasuries. Not today. Pre-re munis maturing in 2014 were recently yielding 1.7%, the same yield offered by the Treasury. So here's an opportunity to pick up something no more risky than a Treasury but, for anybody in the 30% tax bracket, with a considerably better income stream.