Munis in the bargain bin, again

The recent “taper-tantrum” over the Fed’s potential coming removal of quantitative easing has caused quite some unrest in the bond market. This has caused interest rates, in particular longer term rates (10yrs +) to move substantially higher across the board. Long term munis were no exception and the sell off has left some compelling value in long term munis for long term investors.

The chart below takes a long term look (from 1954) at the 20 year muni bond buyer index vs the 20 year US Treasury. Data points are monthly and can be found at the Federal Reserve site. I also charted the spread between the two and US inflation measured by the CPI-All items (I use a 3 month moving average of the annualized monthly figures.

.

Two important things to note in the chart. In general, long rates follow inflation. Rates rose from the early fifties all the way through the late 70s, early 80s, and have been in a downtrend since, largely due to inflation. Starting around 2000, things change a bit. Inflation is pretty much flat but rates trend down anyway, most likely due to lower real economic growth. The point is that inflation is a major part of nominal interest rates. The second thing to note in the chart is that the spread between 20yr munis and the 20yr UST went negative (meaning munis yield more than UST) during the financial crisis and have not been positive since. For example, currently 20 yr munis yield about 4.37% vs 20 yr UST at 3.11%. And that’s not taking into account the tax benefit from munis. In other words, since the financial crisis investors think the credit risk associated with munis far outweighs any tax benefit. This has never been the case in the past. There are several confusing factors here that are worth simplifying.

There is a saying the “you eat real returns”. Basically, after inflation, real, returns are what matter to your quality of life. I’d go one further and add taxes to that so what’s important to look at are after tax real returns. I took the long term data from the chart above and subtracted out inflation and taxes (assuming a mild 25% nominal rate). The table below shows the results before and after adjustment.

In the first table compares nominal and real real returns to their long term averages. Today’s 20 yr munis at 4.37% are yielding 21% less than their long term average of 5.52%, while 20 yr USTs at 3.11% are yielding 50% less than their long term average of 6.17%. And the current spread of -1.26% is way outside the normal spread of 0.85%. On a nominal basis, munis are a better relative value than treasuries. On a real basis the difference is even more striking. The current real rate for munis at 3.07% is 72% above its long term real average of 1.79% while treasuries are still well below their long term average. Then we need to adjust the rates for income taxes. In the second table I adjusted the UST rates down to account for a 25% marginal tax rate. Net net on a real tax equivalent basis long term munis are yielding 3.07% versus their long term average of 1.79% while long term treasuries are yielding a skimpy 1.36%. All in all long term munis look like a good value. The results are even more compelling if you’re in higher tax brackets and/or live in a  state with income tax.

But it can be even better. Most investors don’t buy a portfolio of munis yielding the current interest rate. We buy existing portfolios of muni bonds through mutual funds, ETFs, or closed-end funds (CEFs). One of the reasons I like CEFs vs mutual funds or ETFs is that I’m not subject to the vagaries of fund inflows and outflows. The CEF managers are not forced to sell investments due to investor redemptions nor are forced to buy en masse at highs due to large inflows. I also like that prices can trade at premiums or discounts to the net asset values of the funds. So, in a sell off like the one we’ve had the funds can be bought for some nice discounts. Take the largest value muni CEF around NUV. As of yesterday it yields 4.82%. The portfolio of bonds it holds have an average price $87.60, about 12% below par so you have built in capital gains. And you can buy it at a 4.6% discount to NAV. And if you’re willing to take on a fund with some leverage and the associated volatility there are examples like KSM which yield 7.17% and is priced right at its NAV. These are just examples, not recommendations. CEF Connect is the best site to research CEFs and the CEF discussion board at Morningstar is a great resource as well.

What if rates continue to go up? For long term investors that’s not such a terrible thing. While the market price of your bond funds may go down your income stream will start to go up. As the bonds in a portfolio mature and the fund reinvests the principal in newer issue bonds the dividend payments from bond funds will go up over time in a rising rate environment.

In summary, long term munis are priced at compelling values on a relative and absolute basis, in particular when you look at the rates that matter, real tax after tax yields.