As Investors Flee, Is It Time to Buy Munis?

Michael Sheehan

The muni-bond market has been in a free-fall lately on fears that struggling state and local governments may default on their debts. The resulting imbalance in the bond markets may prove to be a buying opportunity for investors willing to stomach a bit of risk.

When the recession hit, it took a huge bite out of state and local government revenues. The result was free-fall in the municipal-bond market, as skittish investors fled to the relative safety of federal government backed Treasury securities. A flood of new muni issues, coupled with weak demand, also pressured muni prices and bond yields, which move in the opposite direction of prices, jumped. The resulting imbalance between Treasury and muni yields is now making munis more attractive.

The recent yield on a 10-year Treasury note was 2.92%, compared to a 3.12% yield on an AAA-rated 10-year municipal bond. That may not sound like a big difference, but after you throw in the tax advantages of munis, the deal looks a lot better. Munis are free from federal taxes and often from state and local taxes as well. In high-tax states, such as California and New York, the state tax exemption can be a big advantage.

The math can be compelling. Although the interest on a Treasury bond is free from state and local taxes, federal taxes still apply, so your 2.92% yield would shrink to an after-tax gain of 2.19%, if you’re in the 25% tax bracket. In contrast, the equivalent taxable yield on the 3.12% muni is 4.12%. In California, where the state would grab another 9.95% in taxes, the taxable equivalent yield on a 3.12% muni would be close to 4.5%.

The risks are real, however. Battered by mortgage defaults and the stagnant economy, many state and local governments are in a tight fiscal bind. Righting the revenue ship often means raising taxes or cutting back on government services, which can hamstring an already weak economy and lead to higher unemployment. That said, the default rate on AAA-rated bonds traditionally has been close to zero.

If you want to get into the muni-bond market, a mutual fund held in a taxable account is usually the best way to do it. (Generally, you want to keep investments that generate taxable income in your tax-deferred savings accounts.) As with equity mutual funds, the key is to find one with low expenses. If a fund charges you 1% to manage your money, and its yield is 4%, a quarter of your profit is going into the fund manager’s pocket. Three low-cost muni funds to consider are the Vanguard Intermediate-Term Treasury (VFITX) fund (expense ratio 0.25%, year-to-date return 9.47%); the Fidelity Intermediate Municipal Income (FLTMX) fund, with an expense ratio of 0.41% and a yield of 3.69% year-to-date; and the T. Rowe Price Summit Municipal Intermediate (PRSMX) fund, which is yielding 3.44% year-to-date with an expense ratio of 0.50%.