Municipal bond prices make them attractive to buyers

Published 12:00 am Sunday, June 7, 2009

Like much of the global financial industry, the fixed income market experienced significant volatility throughout 2008, forcing many investors to reevaluate their tolerance for risk in their investments, municipal bonds being no exception. However, municipal bond prices have come under considerable pressure in recent months for various reasons creating a particularly attractive buying opportunity for value-minded fixed income investors.

Municipal bonds are typically evaluated on the basis of their taxable equivalent yield, or the yield needed from a taxable bond with comparable risk characteristics to generate the same after-tax return. Consider, for example, a municipal bond yielding 4.00 percent.

The TEY for a fully-taxable bond for an investor in the 35 percent tax bracket would be 6.15 percent, whereas the TEY for an investor in the 20 percent bracket would be only 5.00 percent.

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Therefore, the attractiveness of municipal bonds relative to their taxable counterparts hinges in large part upon the investor’s tax status.

One useful metric for identifying “relative value” in the municipal market is the ratio between the yields from municipal bonds and those from U.S. Treasury securities with similar maturities, or the Municipal/Treasury ratio. The Municipal/Treasury ratio has traditionally hovered in the 80 percent range, but current Municipal/Treasury ratios are registering at levels ranging from 85 percent to 130 percent, signifying that municipal bonds appear undervalued.

It should be noted that several factors might provide justification for some of the recent increases in the Municipal/Treasury ratio. A prolonged period of economic weakness may test some municipal issuers’ debt servicing ability since most municipalities derive a significant portion of revenues from property and sales taxes. Additionally, there remains some degree of concern about the financial strength of the bond insurers, making it more important than ever for fixed income investors to be mindful about the credit strength of the underlying issuer.

However, much of the recent price pressure appears to be related to more technical factors, including forced selling by leveraged investors and mutual funds facing shareholder redemptions. This presents an attractive opportunity for income-seeking investors to capture attractive relative returns from municipal bonds, particularly after weighing the possibility of higher tax rates in the future.

Forrest A. Johnson III, CFP is a financial advisor and vice president with Morgan Keegan and Company Inc., in Natchez.