Yield Shoppers: Look to Munis If Going ‘Long’

An unfortunate confluence of events in the tax-exempt municipal bond market is making for exceptional bargains among longer-term issues--where yields in effect are in the double-digit range for high tax bracket investors.

Muni investors who favor shorter-term bonds, however, will find that yields on those issues are downright lousy right now. In fact, taxable U.S. Treasury notes look like a far better buy for investors otherwise inclined to buy shorter-term munis.

The end of the year is usually a time when sharp investors hunt for muni bond bargains, because sellers often dominate the market through Dec. 31. Then, historically, the muni market rallies in January, sending yields down and bond prices up.

The year-end selling pressure typically arises as individual investors (who dominate the muni market) clean up their portfolios for tax reasons. In years when bond prices decline--as they have this year--many investors do bond “swaps,” selling depressed issues to get a tax loss, then using the proceeds to buy another bond or bond-like investment that pays an even higher yield.

Institutional muni investors, such as mutual funds, also rearrange their portfolios at the end of the year, selling bonds and boosting “cash” levels so that they’re prepared for potential redemptions by shareholders.

Once January arrives, however, the muni market often sees the selling dry up. Meanwhile, semi-annual interest payments received on outstanding muni bonds as of Jan. 1 create billions of dollars looking for a home--and many of those dollars wind up being reinvested in the muni market, sparking a rally.

But this year, some bond pros are dubious about a January rally in the muni market overall. One big negative is the continuing fallout from the Orange County bankruptcy debacle, which has made investors wary of other potential credit-related problems lurking among muni issuers.

Indeed, on Tuesday bond-rating agency Fitch Investors Service downgraded Washington D.C.’s general obligation bonds to BBB-plus from A-minus, citing the city’s deteriorating finances.

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The bidding war between the White House and Congress over a federal income tax-cut bill also is causing some investors to step back from the muni market, experts say. The reason: Lower federal tax rates would remove some of the incentive to seek the tax-exempt income paid by muni bonds.

Finally, expectations of further interest rate increases by the Federal Reserve Board in 1995 make many investors leery of locking money up in any type of long-term bond. So what demand there is for muni issues is concentrated in shorter-term bonds, generally those maturing in less than five years, bond pros say.

But as a result of all of this, muni experts say long-term muni bonds are going begging for buyers--and are offering yields that should be high enough to compensate for all of the inherent risks.

The Bond Buyer index of 40 high-quality long-term muni bonds now sports an average yield of 6.94%, tax-free. That is the same as a 10% taxable yield--such as on a Treasury bond--for investors in the 31% marginal federal tax bracket (which begins at taxable income of $94,250 in 1995 for marrieds filing jointly).

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As most yield-savvy investors know, you simply can’t find 10% taxable yields today except on high-risk corporate “junk” bonds. And the highest yield you can find on U.S. Treasury issues is 7.84% on 30-year bonds. Which suggests that anyone interested in locking in long-term yields at this point ought to be looking to muni bonds, not Treasuries.

The opposite is true if you’re shopping for shorter-term bonds. Example: The average yield on AAA-rated general obligation muni bonds maturing in three years is about 5.2%, according to yield-tracker Municipal Market Data. For a married couple in the 31% tax bracket, that’s equivalent to a 7.5% taxable yield.

But given that three-year U.S. Treasury notes themselves now yield 7.7%, they’re obviously a better buy than munis.

To express the differences in the muni and Treasury market another way, consider the “spread” between two-year and 30-year yields in each market:

* Top-rated two-year muni general obligation bond yields average about 4.9%, while the Bond Buyer index of long-term muni issues now is 6.94%. So the incentive for “going long” in munis is two full percentage points.

* In contrast, 30-year Treasury bonds, at 7.84%, pay just 0.29-point more than two-year T-notes, which yield 7.55%.

Many investors may rationally balk at buying long-term bonds of any kind, of course. If long-term yields surge again in 1995, bond prices will plummet. Still, buy-and-hold investors who are shopping for the best yields should definitely give long-term munis (or long-term muni mutual funds) a close look, many pros say. A 10% annualized return is nothing to sneeze at.

On the other hand, if you’re inclined to play it safe by staying in shorter-term bonds, Treasuries are a more lucrative investment than munis today.

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