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Bye-Bye Municipal Bond Benchmark

Elizabeth Stanton

How cheap are municipal bonds?

That question has become tough to answer due to the increasing scarcity of long-term Treasury bonds. A key measure of whether muni bonds are cheap or expensive relative to taxable bonds has become pretty useless, muni-market participants say.

How's that? The key feature of muni bonds is the exemption of their interest from federal income tax. That exemption has monetary value. As a result, investors are willing to accept lower yields on muni bonds than on taxable bonds. But only if on an after-tax basis, a muni yield beats a taxable yield.

In some respects, the method for determining whether a muni bond (or a muni-bond mutual fund) is a worthwhile buy hasn't changed at all. An investor looking at a muni bond can calculate its taxable-equivalent yield -- the taxable yield that equates to the yield on the muni bond -- by dividing the muni yield by 1, minus your marginal tax rate.

For example, a muni bond yielding 5% is worth 7.25% to an investor in the 31% bracket. If the investor can find a taxable bond yielding more than 7.25% that he would just as soon buy as the muni, the taxable bond is the better deal. (For a bunch of variations on this basic formula, depending on whether you pay state income tax and whether you deduct your state tax payment on your federal return, see our guide.)

Alternatively, an investor looking at a taxable bond can calculate its after-tax yield -- a figure that can be compared directly to a muni yield -- by multiplying the taxable yield by 1, minus your marginal tax rate. For example, a taxable bond yielding 8% has an after-tax yield of 5.52% for an investor in the 31% bracket.

Investors on the fence about whether to buy muni bonds or taxable bonds have long been performing these calculations, and there's no reason they shouldn't continue to do so. The measure that is falling out of favor because of the increasing scarcity of long-term Treasury bonds is a kind of a shorthand version, but one that investors might want to set aside if they hear it in a sales pitch.

In this version, a representative muni yield is divided by the 30-year Treasury bond's yield to calculate what percentage of the Treasury yield the muni yield offers. For example, if a long-maturity muni is yielding 5% and the 30-year Treasury is yielding 6%, then the muni yield offers 83% of the Treasury yield. Implicitly, if you will have less than 83% of the Treasury yield after taxes (because you will be taxed at a rate higher than 17%), it makes more sense to buy the muni rather than the Treasury.

Institutional investors have long studied this metric for buy and sell signals in the muni market. They looked at the current ratio -- often using the Bond Buyer 20 Index as a proxy for munis -- and compared it to its long-term historical average. If munis were cheaper than their long-term average (if the ratio was higher than its long-term average of around 85%), they would buy. When the ratio reverted to the mean, or average, they would sell.

Individual investors, meanwhile, may have heard brokers cite high "ratios to Treasuries" as a reason to pounce on munis. After all, if you can get close to 100% of a Treasury yield from a tax-free muni, why wouldn't you?

Well, as it happens, a powerful reason not to has emerged along with the federal budget surplus. Treasury bonds are how the federal government finances budget deficits. Now that there is a surplus, the government is issuing fewer new bonds than it has old bonds maturing, causing the supply of Treasury bonds to shrink. With shrinking supply, prices have risen, driving Treasury yields lower.

As a result, muni ratios to Treasuries have spiked high above their long-term average, as this chart shows.

Muni yields as measured by the Bond Buyer 20 Index are nearly as high as the 30-year Treasury bond's yield. That last happened in the fall of 1998, when financial markets around the globe melted down and investors wanted to own Treasuries almost exclusively. Before that, the only time muni yields approached or exceeded Treasury yields was in 1986, when federal tax reform disrupted the relationships between outstanding munis and Treasuries. Even in 1995, when the new Republican majority in Congress was promoting fundamental tax reform, muni ratios to Treasuries never got much higher than 90%.

So are munis cheap? They are if the only other investment you'd consider buying is a Treasury. But if you have the least bit of tolerance for credit risk, it might make sense to forget about the comparison to Treasury yields and compare munis to a class of bonds whose yields are unaffected by the Treasury supply crunch, such as high-quality corporate bonds.

"To use Treasuries as a benchmark for relative value is not the best thing to use, because it may not be unusual [in the future] for munis to yield the same as Treasuries" or even more than Treasuries, says Sheila Amoroso, head of the municipal bond department at Franklin Templeton, the leader in open-end muni-bond fund assets under management. In other words, if the supply of Treasuries keeps shrinking, muni yield ratios of 100% or more will become the norm. "The appropriate thing to use is taxable-equivalent yield, or after-tax yield on taxable products," Amoroso says.

Among institutional investors, the search for a metric to replace ratios to Treasuries has focused mainly on high-quality corporate and federal agency bonds. Federal agency bonds are issued by government-sponsored enterprises, or GSEs, including Fannie Mae (FNM) and Freddie Mac (FRE). Some even argue that high-quality corporate and agency bonds make for a better comparison with munis than Treasuries do since both carry some risk of default, which Treasuries do not. "There's definitely a credit element to both," says Chris Dillon, muni-bond strategist at J.P. Morgan.

As this chart shows, muni yields as a percentage of triple-A-rated corporate bond yields are anything but high by historical standards, indicating that an investor choosing between a muni bond and a high-quality corporate bond might be inclined to favor the corporate.

But while muni bond professionals mostly agree that ratios to Treasuries is no longer a useful metric, some are also uneasy with the comparison to corporate bonds, for the simple reason that municipalities are governments, not corporations. Municipalities encounter financial stress, but unlike corporations, they don't go away. "Agencies are probably the best comparison, but they're not as clean as Treasuries, that's for sure," says David MacEwen, muni-bond portfolio manager at American Century Investments. "Munis don't just disappear like corporations can."

"I'm not ready to give it up," adds Richard Ciccarone, who heads the muni-bond department at Van Kampen Funds. "You need to have a no-credit instrument to compare it to. As long as those Treasury bonds are being sold and offered to the public, they're still valid. You're still making a choice."

Fortunately for individual investors, the solution is fairly simple. Unless the only other kind of bond you'd consider buying is a Treasury, never mind the ratios. Do the math on the taxable bond you'd buy instead, and see how it compares.