Time to buy munis?

I’ve been looking at municipal bonds recently. Whenever I see a large sell off in any asset class accompanied with a lot of media hype the contrarian hairs in the back of my neck tend to perk up. All markets tend to over react more often than not. These over reactions can give patient long term investors great opportunities. So, the question I posed to myself recently was ‘are municipal bonds a good value right now?’ Lets find out.

Most investor have heard about the sell off in municipal bonds, driven by the ‘crisis’ in state, local, and municipal governments. I encourage you to look at the Meridith Whitney interview on 60 minutes to get a nice summary of the bear case for munis. Or this article gives a great summary picture of the potential problem. Because of these concerns muni bond prices have fallen significantly since September of 2010, about 10%, which is quite a big move for a government bond index. For example the muni bond ETF, MUB, is off about 10% since that time. As long term investor the first thin I do is turn to history as a guide.

I went to the federal reserve website and downloaded historical data on municipal bond yields and the 10yr US treasury note to compare the relative prices of these two bond types. Long term perspectives can give an investor some great insights. Here is a chart of the spread between 20yr muni yields vs 10yr US Treasury yields going back to the mid 70s.

As the chart shows the average spread over time is about negative 1% and the 90th percentile point of the spread is 0.66%. The spread as of the end of 2010 is now1.61%! Only in the financial crisis of 2008 have spreads been this high. At least by the indication of the spread to government bonds munis seem to offering some value. For example, you can buy the municipal ETF, MUB, at a tax free yield of 3.76% (5.1% tax equivalent yield @ 25% tax bracket) as compared to the US long bond ETF, TLT, at a yield of 4.15%. Or you can buy one of the best muni funds in the business, FTABX, at a tax free yield of 4.21%. There is definitely an indication of value at these prices. Of course, if the nightmare story of defaults comes to fruition these yields could turn out to be value traps.

There are indications that the muni sell off is an over reaction and that the problem at the states and local level is not as bad as people fear. A note from value investors, Cumberland Advisors, makes its case for an over reaction here. They say;

The tax arbitrage test in Muniland is at an extreme.  At a 35% federal rate, the entire curve of Muni yields from 3 months to 30 years is higher than treasuries.  In fact, this is true when tested at the 25% tax rate.  Such a comparison is extraordinary and rare.  Climax?

And as it turns out, very quietly, state/local revenues are starting to turn.

The U.S. Census Bureau tracks the various line items of receipts for governments, and the news is that in the third quarter of 2010 on a year-over-year basis total tax receipts were up 5.2%, from $270.2 billion to $284.3 billion. As the graph below shows, clearly there is seasonality to these numbers, but municipal revenues in the third quarter 2010 are just below the record for any third quarter, set in 2008.

Also, the bond king himself, Bill Gross, agrees and has been buying munis with his own money. In general, I think people are forgetting the revenue generating power of state/local governments and the many constitutional protections for muni bond investors in most states.

I summary, there seems to be significant value in municipal bonds right now. The sell off seems to be over done and the yields offered by tax free munis vs taxable treasuries is extremely compelling. A conservative income investor could do quite well with an investment in munis today. And for the more aggressive income investor muni closed-end funds offer even higher tax free yields for not much more risk. Even compared to taxable junk bond funds or their taxable CEF bretheren, muni CEFs seem right for the picking. Now I just need to convince myself that they offer better returns for the risk than selling options on under valued stocks.