Buy Side

Muni Yields Tell Different Tales

Municipal bonds simultaneously are historically cheap and historically expensive in the current market environment.

Many munis rated at least single-A all along the yield curve carry yields near 40-year troughs, particularly for higher-grade and shorter-term paper.

However, charting munis relative to other rates - Treasuries, corporate bonds, inflation, certificates of deposit, money market funds - shows muni yields close to all-time highs.

With inflation practically at zero and investors averse to any type of risk, benchmark interest rates are abnormally low. The upshot is slim municipal yields that are nonetheless fat relative to benchmark rates.

"All interest rates are relative to something," said Phil Condon, head of muni portfolio management at DWS Investments. "If you really want to get down to what investors should do, it's a question of what the other alternatives are."

Those alternatives, Condon said, mostly offer either painfully low returns or more risk and volatility than investors find in munis.

Even after a major sell-off in the past month, municipal yields have rarely been lower.

A 3.31% yield on the triple-A scale in 10 years is not far from its trough in nearly three decades of data available at Municipal Market Data.

The average yield on 10-year triple-As since 1980 is 5.56%. The average yield since the beginning of the decade is 3.92%.

Relative to a host of rates investors use to gauge the attractiveness of munis, though, yields are just about the plumpest they have ever been.

On almost every spot on the yield curve and every rung of the credit ladder, municipals yield more relative to Treasuries than they ever did until last year.

A 30-year single-A maturity yields 155% of the 30-year Treasury, according to MMD. The average yield ratio since 2000 is 103%.

George Friedlander, managing director and fixed-income strategist at Citi, said the Federal Reserve's efforts to hold down interest rates have dragged down yields on many short-term alternatives to munis.

Yields on those alternatives - money-market funds, CDs, Treasuries - are "pathetic" and "deathly low," Friedlander said.

According to Bankrate.com, the average six-month CD pays 1.58%. Many money market funds yield fractions of 1%.

Another factor to consider is inflation.

The average yield on mixed-quality munis with maturities of at least 20 years, at 13.3% in January 1982 according to the Federal Reserve, would seem a high absolute yield.

Considering the rate of inflation that month was 8.4%, though, the real rate of return was far lower.

Now that the inflation rate is a negligible 0.03% as of January, the real return on munis - even at low absolute yields - is comparatively high, Condon said.

Municipal yields are also rich compared with interbank loans. Since 2000, the triple-A 30-year has yielded an average of less than 90% of the 30-year London Interbank Offered Rate, based on interest-rate swaps.

Currently, the triple-A 30-year yields 145% of the 30-year Libor swap yield, according to MMD.

Mixed-quality munis with maturities of 20 years or more bear rich yields compared with high-quality corporate bonds too, according to Fed data.

Municipals have yielded an average of about 80% of triple-A rated corporate bond yields since 2000. They currently yield more than 90% of high-quality corporates.

Another factor enhancing the appeal of munis is the calamitous performance of the stock market.

Aside from the Dow Jones industrial average plummeting from more than 14,000 in October 2007 to less than 7,000 this month, blue-chip companies including JPMorgan Chase & Co., General Electric Co., Dow Chemical Co., and Pfizer Inc. have slashed their dividends.

Lighter dividend payments make the coupon payments on bonds seem more attractive by comparison.

"Certainly the individual investor has got to be happy with the relationship that munis have to other instruments," said John Colleary, director of fixed income at CFM Advisors Inc. "I'm having very little problem advocating high-grade munis to my clients, given the current climate."

Colleary advises staying in maturities of 10 years or less. Relative municipal yields may seem rich when the federal funds rate scratches near zero. But he expects rates to rise over time, at which point the current muni-Treasury yield ratio will be little solace to investors stuck with market losses on long-term bonds.

"I realize everyone is saying munis have never been cheaper," he said. "You could have all the arguments you want about how cheap munis are relative to Treasuries or corporates. Sometimes no matter how good munis look, you're still not going to buy them because you run the risk of rates going up, and you get hammered."


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