Muni Bonds Weather the Storm

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%.