As Bush's tax cuts face imminent expiry, muni bonds look more attractive

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Similarly, Dan Solender, director of municipal bonds at Lord Abbett, explains that rising taxes “could lift the tax-equivalent yields on municipal securities to levels that are equal to or higher than long-term historical returns for equities, while presenting less historical credit risk than many investment alternatives.”

Solender compares high-yield municipal and high-yield corporate bonds under a higher tax structure environment.

He cites that the Bank of America/Merrill Lynch High Yield Master II Index (a widely accepted benchmark for the performance of high-yield securities) yielded 9.18 percent as of June 30, 2010, or 237 basis points more than the 6.81 percent yield on the Barclays Capital High Yield Municipal Bond Index.

However, when taxes are taken into account, Solender notes that the tax-equivalent yield on the high-yield municipal index jumps to 10.48 percent (based on the top tax rate of 35 percent for 2010); or 12.03 percent (when using the top scheduled tax rate of 43.4 percent for 2013.)

Also, the historical credit performance of the high-yield municipal and corporate bond markets has evinced quite a divergence.

For example, Solender indicates, the average one-year default rate for speculative-grade municipal securities from 1970 through 2009 was only 1.05 percent, compared with a figure of 4.53 percent for speculative-grade corporate bonds during the same time period.

“A similar default rate relationship exists within the investment-grade municipal and corporate bond markets, except on a smaller scale,” he added.

Solender further points out that the tax-equivalent annualized returns for both the high-yield and investment-grade municipal markets have exceeded those of much of the taxable bond universe.

“And the municipal securities have done so with less volatility (as measured by standard deviation) than most of their taxable counterparts,” he stated.

Munis, as an asset class, remain relatively attractive, despite the fact that the potential expiry of the Bush tax cuts have been pondered in financial markets for quite some time.

For example, Solender notes that the yield on the Barclays Capital High-Yield Municipal Index was about 74 percent of the yield on the Barclays Capital U.S. High-Yield (Corporate) Index at the end of June 2010. That ratio was well above the average of 69 percent since December 1995.

Put another way, Solender explains that the yield relationship between high-yield municipal and high-yield corporate bonds was historically tight as of June 2010.
“Therefore, reverting to the long-term average would entail lower municipal yields (indicating price appreciation), higher corporate yields (indicating price depreciation), or both,” he said.

What makes municipal bonds even more attractive is that there aren't that much of them around. A tight supply of munis will surely heighten demand -- again, raising their value.

“During the depths of the financial crisis, in late 2008 when Lehman Brothers collapsed, demand for municipal bonds virtually vanished,” Flugrath said. “Their supply on the market has been quite limited ever since.”

Since the introduction of the popular Build America Bonds – a type of quasi-muni bond which have attracted buyers since they are backed by the federal government and therefore carry a zero percent chance of default, although they are taxable – the supply of tax-exempt muni bonds on the market has significantly declined.

Flugrath cautioned that investors should look closely at the credit quality of a muni bond before making a purchase. Given the plethora of local and state governments that are facing the prospect of going broke – especially in hard-hit California – default is a possibility (though probably unlikely).

“If a municipality defaults, bondholders might not get paid anything for a while, so there is a small risk,” he said.