The Yields are Staggering - Tax Free Muni Bonds (Barrons)

Monday, October 20, 2008






The Yields Are Staggering
By ANDREW BARY

Many munis are battered -- but hardly broken. Patience will pay.

THE CREDIT MARKET'S WOES are benefitting one group: buyers of municipal bonds, who have seen prices plunge and yields soar. Munis, some of which offer long-term tax-free yields topping 6%, have almost never looked so attractive, relative to U.S. Treasuries.

"The market is way undervalued," says Laura Milner, a portfolio manager at SCM Advisors in San Francisco. "It's more the result of liquidity than credit problems. You don't have to stretch in terms of credit quality to get high yields." She favors state general-obligation bonds and revenue bonds for essential services, like water and sewers.

THE MARKET HAS BEEN HURT by selling pressure from hedge funds, issuers of structured notes and mutual funds, which have been experiencing redemptions. Buyers have been scarce, with retail investors now the main source of demand. The problem is that individuals can absorb only so much supply. There also is concern that the weakening economy will lead to gaping budget deficits at state and local governments, hurting the credit quality of municipal debt. Investors can take comfort, however, in the fact that munis historically have had much better credit performance than corporate bonds. Even during the Great Depression, no state defaulted on its general-obligation bonds, and overall muni default rates remained very low.

Just last week, 30-year bonds backed by the triple-A-rated Texas Permanent School Fund (PSF), one of the premier muni guarantors, were sold at a yield of 6.25%. Double-A-rated New York City issued $500 million of general-obligation bonds at a top yield of 6.40%. Top-grade 10-year debt recently has been yielding 5% or more.


Lars Leetaru for Barron's
"The yields are staggering," says Jim Evans, who heads the muni investment group at M.D. Sass in New York. Evans points to the top yield on the Texas PSF bonds and to recent secondary-market offerings in which 20-year pre-refunded California GOs traded at a yield of 5.85%. Pre-refunded bonds probably are the safest bonds in the muni market because they're secured by U.S. Treasuries. Long-term debt from other top issuers, like Harvard University, yields nearly 6%

A 6% muni yield is equivalent to a 10% taxable yield for residents of high income-tax states like California, New Jersey and New York. This assumes that residents buy in-state bonds. Tax-equivalent yields for out-of-state bonds are around 9%. The allure of munis could grow if presidential front-runner Barack Obama wins the election because he has vowed to raise taxes on Americans making more than $250,000 a year. Some analysts expect Obama to seek to lift the maximum income-tax rate to 40% from the current 35%, which now applies to married couples earning over $357,700 a year.



The 5.9% yield on 30-year, AAA-rated munis now is roughly 135% of the 4.3% yield on the 30-year Treasury. That's by far the highest ratio in the past 20 years, exceeding the prior peak of 115% set early this year. Long-term municipals historically have yielded slightly less than Treasuries because of the tax benefits.

Despite weak demand for long-term issues, California just sold $5 billion of short-term revenue-anticipation notes maturing in 2009, including $3.8 billion of eight-month notes at a 4.25% yield. That yield is very attractive, relative to the 1% rate on Treasury bills. The interest is tax-free to California residents, who face a punishing state income-tax rate of 9.3% for couples earnings over $93,000 annually and 10.3% for income above $1 million.

Muni issuance has slowed dramatically this month as state and local governments have heeded the advice of investment bankers to wait for a more receptive market. If demand picks up -- and high yields could create demand -- supply might be easily absorbed, and market conditions could improve quickly, as they did after a sell-off in February and March.

Investors have plenty of ways to play the muni market, including individual bonds, open-end mutual funds, closed-end funds and relatively new exchange-traded funds like the iShares S&P National Muni Bond (MUB). Well-run open-end funds include the $19 billlion Vanguard Intermediate-Term Tax-Exempt (VWITX) and the Bernstein Diversified Municipal (SNDPX), which have held up well this year, as well as Legg Mason Partners Managed Municipals (SMMOX), co-run by veteran Joe Deane, one of the best managers in the business.

CLOSED-END MUNI FUNDS BECKON because they came under extreme selling pressure early this month, with many finishing Friday, Oct. 10, at record discounts of 30% or more to their net asset values, way above the typical level of no more than 10% or 15%. Exchange-traded closed-ends rallied sharply last Monday, and their discounts now generally are below 20%.

The accompanying table lists a few closed-end funds now trading at double-digit discounts and yielding more than 7%. The high closed-end yields reflect the discounts and leverage. Many funds buy $3 of bonds using $2 of investor funds and $1 of borrowings. The leverage results in higher volatility than is common at open-end funds; year-to-date total returns of many closed-ends were a negative 20% or worse at mid-week, according to Morningstar, versus declines of around 10% for many long-term open-end funds. The losses to closed-end investors have been even greater than 20% because market prices often slip more than NAVs, on which the reported performance data are based. There's a risk that some closed-ends will reduce leverage, diminishing their yields.

PROBABLY THE HARDEST-HIT big municipal fund this year is the $5.9 billion Oppenheimer Rochester National Municipals (ORNAX), which was off 37% through Thursday, by far the worst showing among the 50 largest open-end muni funds.

The aggressive fund aims to generate high yields through ownership of low-rated or unrated munis. It buys gamier securities like land-development bonds, tobacco bonds backed by state revenues from the 1998 mass settlement with major cigarette companies, airport-revenue bonds and "inverse floaters," whose yields move in the opposite direction of short-term rates. With muni short rates elevated, prices of inverse floaters have come under pressure.

Prices of bonds in the Rochester portfolio have fallen sharply as investors favor high-grade munis with ratings of AA and higher. "I've been doing this since the late 1970s, and this is by far the worst I've seen it. It's an ugly market out there," says Ron Fielding, senior portfolio manager of the fund. Because of recent investor redemptions, Oppenheimer's Rochester has been forced to sell bonds in an illiquid market.

Fielding says the good news is that the credit quality of both the Oppenheimer Rochester National Municipals fund and the larger $9 billion New York-oriented Rochester Fund Municipals (RMUNX) is strong with minimal defaults. The main near-term risk is that the funds will need to sell more bonds to meet additional redemptions. The national fund's current yield now stands at 10%.

Reflecting the investor preference for high-grade munis, the yield gap between triple-A and triple-B munis has widened to a near-record two percentage points.

Even among highly rated bonds, investors are showing a preference for general-obligation bonds and revenue bonds from well-regarded issuers like the Los Angeles Department of Water and Power and the Port Authority of New York and New Jersey.

The Bottom Line:

Municipal bonds are trading at unusually low prices and rare yields. They've almost never looked as attractive when compared with U.S. Treasury securities.A BLOCK OF BONDS issued by Goldman Sachs for construction of its new headquarters in lower Manhattan traded recently at a yield of about 7.75%. Those New York Liberty 5¼s of 2035 are backed by Goldman and have double-A credit ratings.

With the municipal-bond market roiled by liquidity problems, investors now can get 5% on intermediate-term debt and 6% on long-term issues. That seems awfully attractive with inflation likely waning and the presidential front-runner vowing to boost taxes on anyone making $250,000 or more a year.


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