Low prices create tax-free opportunities
As the credit crisis lingers and recession fears spread, a lot of babies are being thrown out with the bath water.
Skittish investors have dumped just about everything other than ultrasafe Treasury bills and bonds. The list includes many investments that aren’t all that speculative, such as municipal bonds sold by cities, counties and state-government agencies.
“Our product is pretty cheap right now,” said Todd Curtis, portfolio manager of the Tax-Free Trust of Arizona, a mutual fund that holds bonds issued by Arizona municipalities.
The muni-bond market has been racked by the same jitters that have hit stocks, corporate bonds and other assets. Nervous investors can’t help but note that state and local governments face falling revenues from sales taxes and other sources.
“There is currently a lack of liquidity within the municipal market, which is driving yields to the upside,” wrote William Greiner, chief investment officer at UMB Asset Management in Kansas City, Mo., in a recent report.
It doesn’t help that third-party bond insurance has been undermined by a loss of confidence in companies that provide such coverage.
Previously, it was common for municipalities to pay fees to insure their bonds, thereby receiving the rating enjoyed by the insurer itself, usually triple-A. Yet that system isn’t working well at the moment as many insurers find their own financial strength downgraded.
“Bond insurance now has no meaning,” Curtis said at a Tax-Free Trust of Arizona shareholder meeting in Phoenix.
As a sidenote, the many problems facing muni bonds, combined with the decreased value of bond insurance, make it more important than ever to build diversification into your portfolio. You can do this with mutual funds or other professionally managed portfolios, or by spreading your holdings among numerous bonds.
Even the potential for tax increases with a Democrat sweep of the White House and Congress have not breathed much life into the muni-bond market, although that could come later. Since muni bonds pay interest that avoids federal taxes — and sometimes state taxes, too — they become more valuable when tax rates rise.
To measure relative value, investors frequently compare the yields of munis rated triple A against the yields on Treasuries with similar maturities. Because munis pay tax-free interest, their yields typically run slightly below what Treasuries pay.
Over the past decade, muni yields have averaged between roughly 80 and 90 percent of Treasury yields, Curtis said.
But in light of current market turmoil, triple-A munis and Treasuries currently yield roughly the same, about 5 percent for bonds with 10-year maturities and 5.5 percent for 30-year issues. A few weeks ago, muni prices became so depressed that they briefly yielded 40 percent more than Treasuries.
“That’s practically unheard of,” Curtis said.
On a muni bond yielding 5.5 percent, affluent investors who pay taxes at the 33-percent federal rate would receive the equivalent of an 8.2-percent yield on a taxable bond. If the muni pays interest that avoids both federal and states taxes — or if you pay taxes at a higher rate — the tax-equivalent tradeoff would be more impressive.
“Currently, an investor can capture equity-like returns in the long-term municipal bond market,” wrote Greiner.
Still, to realize those returns, investors must accept price volatility along the way — and lately the road has been bumpy.
For example, muni-bond weakness has sent mutual funds to sizable losses. Muni-bond funds were down 6.1 percent on average, including interest, from Jan. 1 through Oct. 23, reports researcher Lipper Inc.
On the other hand, when muni bonds and bond funds slumped sharply in the past, as in the early 1990s, investors who mustered the courage to buy realized decent returns when the market subsequently recovered.
“There are some very good opportunities now in the muni-bond market,” Curtis said.