Municipal Bonds: What Insurance?

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Wall Street has been having trouble finding investors to buy stocks this week.

Not so with tax-free municipal bonds issued by states, cities and other local government entities.

The average annualized yield on a Bond Buyer index of 40 long-term muni bonds slid to a six-week low of 6.10% on Thursday. Falling interest rates on bonds indicate that investors are hungry for the securities and are seeking to lock in yields.

Matt Fabian, senior analyst at Municipal Market Advisors in Westport, Conn., dubs the muni buying wave a ‘Barack Attack’ -- a reaction to the victory of President-elect Barack Obama and his promise to raise income tax rates on the wealthiest Americans.

‘You have to think it’s people figuring tax rates are going up,’ Fabian said. Higher tax rates naturally would make the tax-exempt yields on munis more appealing.

Obama proposes to raise the top federal income tax bracket to 39.6% from 35%. In the 39.6% bracket a 6.1% tax-free yield would be the same as earning 10.1% on a fully taxable bond. In the 35% bracket the same muni yield would be worth a 9.4% taxable yield.

Even without a tax hike, current muni yields should be luring individual investors. The market still is recovering from a surge of selling in mid-October by hedge funds and other investors who were desperate to raise cash as the credit crunch deepened. That selling wave briefly drove the yield on the Bond Buyer index as high as 8%.

‘It was nutty,’ said George Strickland, a muni fund manager at Thornburg Investment Management in Santa Fe, N.M. ‘You had 10 or 15 sellers for every buyer.’ That was a great opportunity for savvy investors.

Although muni yields have since come down, at 6.10% the Bond Buyer yield still is the highest since 2000, except for the October spike.

But the highest muni yields are on the longest-term bonds -- issues maturing in 30 years or more -- and those typically aren’t favored by individual investors. Many investors prefer bonds maturing in 15 years or less, which pay lower, but still attractive, yields; a 10-year California general obligation bond, for example, is yielding about 4.75% now.

Bob Gore, veteran muni bond trader at brokerage Crowell Weedon & Co. in L.A., said he’s still seeing ‘good demand’ for California general obligation bonds despite the state’s worsening budget woes.

For California, debt repayment isn’t optional -- it’s mandated by the state Constitution.

Still, some market analysts wonder if muni bonds will continue to be as safe as they have been historically. Defaults by muni issuers remain relative rarities, but many issuers, like California, are facing deepening fiscal troubles.

And the public keeps saying yes to more muni bond issuance, raising the long-term supply outlook.

U.S. voters on Tuesday approved at least $45.2 billion in new borrowing, passing about 84% of tax-free bond measures, according to a Bloomberg News preliminary tally.

In California, the biggest muni borrower, voters OK’d measures including nearly $10 billion in bonds for initial funding of a high-speed rail line and $980 million in bonds to finance improvements at children’s hospitals.

If Obama indeed seeks to raise taxes on the highest-income earners, demand for muni issues may just continue to rise, helping states and local governments fund bond borrowings.

But one question to ask is where that money might have been invested otherwise. Will private-sector investments wane because more investors feel compelled to buy public-sector bonds?