Why Municipal Bonds May Be Bargains

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Munis yield over 4%—equivalent of a taxable bond yielding 6% for those in the 33% tax bracket.

As mortgage defaults increased last year, the markets took unnerving turns. Panicked investors raced to buy Treasuries and sell securities that seemed to present risks. Among investments that took a pounding were high-grade municipals.

Shareholders redeemed their stakes in municipal mutual funds and put the cash into rock-solid Treasury investments. With investors bidding up prices of Treasuries, long-term government funds returned 9.8% in 2007. During the same period, long-term municipal funds returned only 1.3%.

Can Treasuries continue outpacing municipals? Probably not. “Municipals now sell at unusual bargain levels,” says Lewis J. Altfest, a financial advisor in New York.

To appreciate the value of municipals, consider how their yields have shifted. Under normal conditions, municipals yield 80% of what Treasuries pay. So when Treasuries yield 5%, municipals pay 4%. Municipals yield less because they are tax free. But the turmoil last year upended normal relationships. As municipal prices dropped, their yields rose.

Meanwhile, Treasury prices rose, and the yields fell. Now plenty of high-grade munis yield more than 4%. That is the equivalent of a taxable bond yielding 6% for someone in the 33% tax bracket. At the same time, 10-year Treasuries—which are taxed by Washington—yield only 3.6%. The last time municipals enjoyed such an edge over Treasuries was in 1999 when investors were selling tax-free bonds to buy Internet stocks. The following year, municipals revived and produced double-digit returns. Tax-free funds could duplicate that feat in 2008.

To cash in, stick with general obligation bonds, says financial advisor Altfest. These are issued by states and cities to raise money for municipal activities, such as paving roads. General obligation bonds rarely default because they are backed by the full taxing power of municipalities. The safest bonds are rated AAA by Standard & Poor's, but Altfest says that investors should also consider bonds that carry the next highest ratings of AA and A.

Some of the biggest bargains are AAA-rated insured bonds, says Tom Metzold, portfolio manager of Eaton Vance National Municipals. In a typical insurance deal, a city issues a bond rated A, says Metzold. Then the city purchases insurance. Because of the extra protection, the bond may be rated AAA. Municipalities buy the insurance because it enables them to pay lower yields on the bonds. If the underlying A-rated bond defaults, the insurance company must make good on all interest and principal payments.
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