Is 2014 a good year to invest in municipal bonds or not?

Market Realist

Geopolitical risks and the municipal bond investment opportunities (Part 10 of 10)

(Continued from Part 9)

Investing in municipal bonds

In the last section, we discussed municipal bond (MUB) issuance in Q1 2014 in terms of key trends observed in the market with respect to maturities, trading volumes and insured municipal bond (PZA) issuance. In this section, we will discuss certain market factors that will tell us whether investing in munis is a good idea or not at the moment.

Muni yield advantage over Treasuries

As most munis are tax-exempt, they generally yield lower than other debt of similar quality and tenor. The ratio of yields on Treasury securities to yields on municipal debt of similar quality, gives an indication of how cheap or expensive munis are relative to Treasuries. The AAA 10-year muni yield to 10-year U.S. Treasury Yield Ratio (or the MUNSMT10 Index) has averaged ~84.9% between January, 2004 to December, 2008, and 102.1% since then (up to April 22, 2014). The ratio comparing AAA 30-year muni yield to 30-year U.S. Treasury Yield Ratio (or the MUNSMT30 Index) has averaged ~96.3% between January, 2004 to December, 2008, and 111.4% since then (up to April 22, 2014).

The higher relative value over the past few years has probably been due to the rich valuations for Treasury securities, brought on by the low interest rate environment and the higher demand for safer assets following the 2008 financial crisis. In the last quarter, relative value ratios have averaged 95.9% and 106.2% for 10 and 30 year maturities respectively. They stood at 88.1% and 101.9% as on April 22, 2014. So the yield advantage appears to be gradually diminishing, although the valuation for the 30-year maturity still appears attractive as they are yielding more than Treasuries.

Spread comparison: GO bonds and Treasuries

AAA-rated 30-year munis yielded 68 basis points more than Treasuries (TLT) even without considering the tax-advantages on muni investments (based on M49 U.S. Muni General Obligation AAA Curve as on 04/22/14 and I25 U.S. Treasury Actives Curve as on 04/23/14). The differential, however, was just 9 basis points for the 10-year munis (MUNI) and 10-year Treasury securities (IEF).

Valuations for municipal securities would look even more attractive once the after-tax yields are considered, and the yield advantage would be higher as the investor’s tax bracket increases.

To find out more about how Tax Equivalent Yields (or TEYs) are computed, read the series, Key benefits of municipal bond investments for your portfolio.

Outlook
Improving economic fundamentals are also expected to improve state finances. Many projects which had been kept on hold following the Great Recession and consequent belt tightening are expected to go on-stream, which should boost issuance, especially revenue bond issuance going forward.

The American Society of Civil Engineers estimates that the US would have to spend ~$3.6 billion by 2020 to make needed infrastructure improvements. An improving economy would see that the necessary structural improvements are made. Those projects, which had been postponed in the past few years due to fiscal austerity following the financial crisis, should see a boom in the sector. Due to the huge spending requirement, there should be more municipal revenue issues to finance projects and also more ETFs like RVNU with exposure to these munis.

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