What's Happening with Muni Bonds?
Traditionally, municipal bonds have been relatively safe investments. Over the past couple of years, however, that market has been extremely volatile, due to several factors:
Credit ratings of bond insurers have been downgraded. Historically, the municipal bond market has experienced very few defaults, making their credit quality relatively high. However, a significant portion of municipal bond investors are individuals, who wanted added assurance that these investments were safe. Thus, in the late 1980s, insurance companies started issuing municipal bond insurance, which grew significantly in popularity. Recently, over 50% of all new municipal bonds obtained this insurance. The bond issuer purchases the insurance when the bonds are brought to market, with the insurance company committing to make timely payment of principal and interest in the event of the bond issuer's default. When the bonds are insured, the bond receives the same rating as the insurance company's rating.
Initially, insurance companies only provided insurance for municipal bonds, but then they started insuring taxable bonds as well. Some of that debt was tied to subprime mortgages, which caused problems for the insurance companies. Due to sizable losses from the subprime mortgage products, the ratings of several insurance companies were downgraded, causing the downgrading of ratings of underlying municipal bonds. While the insurance companies received downgrades to their ratings due to losses on taxable insured bonds, that had a direct impact on municipal bonds. Typically, most of the insured bonds are investment-grade quality, even without the benefit of the insurance. However, many municipal bonds are trading based on the underlying rating of the bond or even lower, with no consideration given for the insurance.
Auctions for auction-rate bonds started to fail. Auction-rate municipal bonds are long-term bonds with maturities of 10 to 30 years that have a floating interest rate. Every seven to 28 days, the bond underwriter holds an auction to reset the interest rate. The auction is a Dutch auction, which means that the interest rate is reset at the lowest rate that results in a sale of all the bonds. For issuers, they are basically issuing long-term bonds at short-term rates. Investors receive a highly liquid bond that can be sold in an upcoming auction, while earning interest rates slightly higher than money market rates. If there are not enough bids to complete the auction, the sellers are not able to sell their bonds, but they receive a predetermined penalty interest rate. Traditionally, if there were not enough buyers, the underwriter would step in and purchase the bonds. In January 2008, an auction failed because the underwriter would not step in. After that, auction failures became widespread, putting further pressure on municipal bonds.
Many institutional investors sold their muni bonds. Some institutional investors had to sell muni bonds because their ratings had dropped below allowable limits. Of more consequence, however, was the fact that billions of dollars of municipal bonds were sold by hedge funds to meet margin calls. Troubled banks, brokers, and insurance companies have also sold massive amounts of muni bonds to raise cash. The end result has been that there are more sellers than buyers, further depressing muni bond prices.
What Is the Current Situation?
Historically, municipal bonds have yielded less than Treasury securities, because their income is exempt from federal income taxes and possibly state and local income taxes. The ratio of yields between the two securities has varied over time, depending on prevailing interest rates and tax rates. For individual investors, the attractiveness of municipal bonds is highly dependent on their individual tax bracket. Municipal bonds with maturities of 10 years or more have typically yielded between 80% and 90% of Treasury bond yields.
Over the past several months, it has not been uncommon to see ratios of 150% to 300%, meaning that the interest rates on municipal bonds are substantially higher than Treasury securities, despite the income tax advantages.
Should You Invest in Municipal Bonds?
By historical measures, municipal bonds are very cheap compared to Treasury securities. On a tax-equivalent basis, assuming you are in the 25% tax bracket, a AAA-rated 10-year municipal bond is yielding 4.31% compared to 3.03% for a 10-year Treasury security. But does that mean that you should purchase them?
The municipal bond market has become very volatile over the past couple of years, and no one knows when or even if it will return to normal levels. However, if the current situation corrects itself and the ratio between Treasuries and munis goes back to more traditional levels, purchasing now makes sense. Also, if income tax rates increase, current yields will be even more attractive on an after-tax basis.
If you purchase individual municipal bonds and hold them to maturity, you will not have to worry about changes in principal value. You will receive all of your principal when the bond matures. And at this point in time, the yields of even the highest-quality municipal bonds are attractive. If you want to reduce your risk, you can purchase intermediate-term muni bonds with investment-grade credit ratings.