Investors are pushing back into municipal bonds, which remain an effective way to generate relatively safe tax-free income

Business Week
By Ben Levisohn

After months of being shunned by investors, municipal bonds are back. AAA-rated municipal bonds now yield just over 3%, well below October's rates of well over 4%. For a 10-year bond with a 4% coupon, that translates to a rise in price to $105.83 from a low of $94.39. The iShares S&P National Municipal Bond exchange-traded fund (MUB), which holds primarily AAA- and AA-rated bonds, has rallied from a low of $88.76 on Oct. 15 to over $100 on Feb. 11, a gain of 13%.

One of the biggest reasons for the rally was the rise—and fall—of Treasury bonds. Historically, munis and Treasuries traded at a fairly constant ratio, with tax-free munis yielding about 85% of taxable Treasuries, with the price of the munis reflecting the tax benefit. But that all changed in 2008. By the year's fourth quarter, terrified investors had scooped up all the U.S. government debt in sight, pushing Treasury yields down near historic lows. At the same time, the municipal bond market froze up, pushing up the yields of munis. By November, a top-rated muni bond yielded almost double a Treasury bond. "You won't see another opportunity in municipals like that for decades," says Matt McCall, an investment adviser at Penn Financial Group.

Now, investors have pushed back into munis, and their yields are roughly equal with Treasuries of comparable maturities. Why the rally? For the first time, investors looking for a safe haven—and wanting to earn something beyond the negligible interest rate offered by Treasuries—looked to AAA-rated munis as an alternative. Investors also speculated that the Federal government's stimulus package would provide aid to states and municipalities, making it less likely they would default on their debt. Crossover bond funds, those not limited in the categories of debt they can purchase, saw an opportunity in bonds as well, rushing in to buy when munis were at their low-point, possibly because government intervention seemed in the offing. And individual investors, witnessing a rise in net-asset values of muni mutual funds rushed in, pushing prices even higher.

Room to Rise Further?

And that has left munis too rich for some investors. "High-grade munis are drastically overbought," says Matt Fabian of Municipal Market Advisors, a municipal bond adviser.

Not everyone agrees. Some proponents of munis point to the ratio between Treasuries and municipals—now at 100%—and say munis still have upside as they should soon trade once again near the traditional yield ratio of around 85% of Treasury bonds. But others say that the link between the two is broken. They point to the fact that historically, all fixed income securities tend to move in lock-step. Rising rates pushed all yields higher and drove prices down; falling rates drove yields down and prices up. But no longer. With Treasury yields falling to negligible levels, almost everything looks cheap, including munis. "When Treasuries are yielding two-and-change [slightly above 2%], other forms of debt look overvalued," says Rollance Verkennis, a partner with the Resource Group, a financial advisory firm in Glendale, Calif.

Municipal bonds face other, fundamental pressures as well. The Senate stimulus bill passed on Feb. 10 cut $40 billion of state aid from the House version—not a good sign for those hoping the Federal government would step in, bolster state and local finances, and thereby rescue the muni market. And some experts claim that some buyers are purchasing AAA-rated bonds in order to sell them to high-grade muni mutual funds, which will continue to buy the bonds as long as investors keep putting money into the funds. As soon as that buying stops, prices of high-grade funds could fall—and send investors fleeing once again.

Low Yields

Finally, the yields on munis are at an all-time low, making it hard to argue that they are "cheap." With credit markets unfreezing—$120 billion of municipal debt was issued in January alone—and municipalities looking to sell even more, it remains to be seen whether investors will still clamor for munis, or whether prices will drop, sending yields higher. "The biggest concern for munis is supply, says Samson Capital Advisors' Benjamin Thompson, who manages municipal-bond portfolios for high-net-worth clients. "The amount of pent-up issuance is likely to be substantial."

But that doesn't mean investors should avoid munis. The bonds remain an effective way to generate relatively safe tax-free income, and with taxes possibly on the rise, that could make munis more attractive. There's also value to be found once investors go a bit lower on the credit-quality ladder—a bit below the AAA- and AA- rated categories, though not into speculative-grade issues. Ron Schwartz, manager of the Ridgeworth High Grade Municipal Bond Fund, has been selling his AAA-rated bonds in favor of lower rated, but still investment grade, munis, which have experienced a much more subdued rally.

"We're seeing greater volatility than we're used to," Samson Capital's Thompson says. "But municipal bonds are still attractive."

Levisohn is a staff editor at BusinessWeek covering finance and personal finance.