Muni Bonds Weather the Storm
Gregg Greenberg
09/26/05 - 07:03 AM EDT
Hurricanes Katrina and Rita have inflicted major damage to bridges and roads across the Southeast. But municipal bond fund managers say the bonds supporting those structures are not buckling. In fact, they may even be bargains.
"There are numerous cases of happy endings for munis after major catastrophes," says Robert Pariseau, portfolio manager for the
(USTEX Quote)USAA Tax Exempt Long-Term bond fund. "Florida suffered through four major storms last year, including Hurricane Ivan, and there were no defaults and no downgrades. The state ended up being upgraded last winter by all the rating agencies."
A municipal, or muni, bond is a debt security issued by a local government to fund capital spending projects such as bridges or sports stadiums. Municipals, as opposed to taxable bonds such as Treasuries and corporates, are exempt from federal taxes and from most state and local taxes, especially if you live in the state where the bond is issued. That is the essence of their attraction.
Munis' favorable tax implications make them a staple in the portfolios of baby boomers close to retirement and a must-have for people in high-income tax brackets, particularly those in states with high state and local taxes, such as New York. And because most muni bonds are insured, their tax-free payouts should be able to withstand most hurricanes no matter where they make landfall.
Winds of Inflation
From Ivan to Katrina to Rita, the winds have been whipping around the Gulf over the past year. The interest rate environment, on the other hand, has remained steady and favorable. Despite the
Fed's best efforts to lift long-term rates via 11 straight fed funds rate hikes, the benchmark 10-year Treasury is near 4.2% -- right where it was last year at this time.
One element that has changed since then is the expectation for inflation. Energy prices have jumped, and prices at the pump haven't been helped by hurricane-related refinery shutdowns. Not enhancing matters is the thought of $61 billion in Katrina relief being pumped into an economy already awash in currency from the housing boom.
If rates do rise to meet the inflationary threat, analysts point to a favorable supply/demand dynamic as one of a number of reasons why munis would be preferable to Treasuries. The primary reason for the positive supply/demand outlook is quite simple: a lack of foreign demand.
Unlike domestic buyers, non-U.S. investors are ineligible for the bonds' significant tax benefits. That means muni prices would hold up well in the event that investors outside America lose their appetite for Treasuries, a scenario that grows increasingly likely as the U.S. budget deficit piles up.
And while the government has increased the supply of Treasury bonds in order to fill the gaps, state and local governments have been issuing bonds for a different reason. John Miller, portfolio manager for the
(NHMAX Quote)Nuveen High Yield Municipal Bond fund, says that new issuance has been heavy this year by municipalities refinancing old debt to clean up their balance sheets. In a so-called refunding deal, however, the old, higher-coupon bonds remain outstanding. This increases supply, and that pushes prices down -- and yields up.
Finally, munis tend to outperform Treasuries and corporates in a rising rate environment because people don't like to part with them. "There is a strong buy-and-hold theme in munis," says Miller.
Valuation Sensation
Valuation is another oft-cited reason for the expected shift from Treasuries to munis. Robert DiMella, portfolio manager for the
(MDMIX Quote)Merrill Lynch Municipal Insured muni fund, says, "Munis are yielding more than 95% of Treasuries. So if you are in a higher tax bracket, munis make huge sense."
Here's what he means by that. Last week, a 30-year triple-A-rated municipal bond was yielding 4.35%, compared with 4.47% for the 30-year Treasury. Dividing the muni yield into the Treasury yield gives you a whopping 97%. Historically, the percentage is closer to 85%.
Now here are the tax advantages of that muni bond using the same example: If you are in the 35% tax bracket, the tax-equivalent yield for this particular muni is 6.69%. (To calculate yield equivalence, divide the tax-exempt yield, in this case 4.35%, by one minus the investor's tax rate, 35%; in other words, divide 4.35% by 0.65.) So on a tax-adjusted basis, you would have to buy a 30-year Treasury yielding 6.69% to match the tax-free returns on a similar muni bond yielding 4.35%. That's tough to do with Treasury bonds yielding something like 4%-4.5%.
Finally, bond strategists say the nation's growing economy means higher tax revenue to service both old and new municipal debt. So what the hurricane knocks down, a growing economy will put back up.
"Municipalities' credit has improved with higher tax revenues and lower deficits over the past year," says Merrill's DiMella. "They are in a far better shape nowadays."
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