Munis Yield More Than Treasuries as State Funds Wane

Banking Analyst Meredith Whitney
Banking analyst Meredith Whitney said in September that the U.S. government will face pressure to bail out struggling states in the next 12 months. Photographer: Jonathan Fickies/Bloomberg

Tax-exempt bonds are yielding more than Treasuries for the first time since the financial crisis, a relationship that history shows doesn’t last, especially as the Federal Reserve kindles inflation expectations.

Investors buying AAA municipal general obligation bonds due in two years get a yield equal to 119 percent of similar-maturity Treasuries, Bloomberg Fair Market Value data show. A ratio above 100 percent means those in the 38.3 percent federal tax bracket get higher yields plus tax-sheltered income. Before the credit crisis in 2008, that happened twice in the 20 years for shorter-maturity debt.

The combination of worsening state and local finances and a surge in sales that included $15.5 billion of offerings last week, the most in more than seven years, has pushed tax-exempt bond payouts above Treasuries. Muni rates rose faster even as yields on 10-year U.S. notes posted the biggest two-week increase in almost a year on speculation the Fed will avoid deflation by purchasing $600 billion of government debt.

“The value pendulum has swung from Treasuries to munis,” said Jonathan Lewis, founding principal of New York-based Samson Capital Advisors LLC, which manages $7.3 billion. “Municipals are a good place to park your money and get a yield advantage that typically wouldn’t be there.”

Shifting to Munis

Lewis shifted money to Treasuries from munis eight months ago when the ratio dropped to as low as 66 percent as the Fed finished $1.7 trillion in asset purchases in the first leg of what’s become known as quantitative easing.

General obligation notes rated AAA due in two years yield 0.70 percent, or 0.19 percentage point more than Treasuries. Over the past 20 years, Treasuries have yielded about 1 percentage point more, according to Bloomberg data.

Losses were magnified by the 6.4 percent average decline in closed-end municipal-bond funds this month through Nov. 18 as concern increased that city and state finances are deteriorating, according to Morningstar. The funds traded at a 0.36 percent premium to net asset values last week, down from about 0.55 percent a month earlier, according to Cecilia Gondor, a closed-end fund analyst at Thomas J Herzfeld Advisors Inc. in Miami.

Losses in closed-end funds helped push up rates even on top-rated issues such as Georgia AAA general obligation bonds due in two years to 125 percent of two-year Treasuries, Bloomberg data show. Maryland National Capital Parks & Planning Commission AAA general obligation bonds due in 2012 yielded as much as 141 percent of comparable Treasuries last week.

‘Relatively Cheap’

“I’ve worked in this business for more than 20 years and ratios getting north of 100 percent of Treasuries happens infrequently, and doesn’t usually last too long,” said Robert Millikan, who helps oversee $19 billion as executive director of Sterling Capital Management Llc in Raleigh, North Carolina.

Fixed-income strategists at New York-based JPMorgan Chase & Co. said in a report dated Nov. 19 that they raised their recommendation on tax-exempt munis to “cautiously positive” from “neutral.” They said all bonds of all maturities are “relatively cheap.”

The relationship between municipal and government debt has been distorted by Fed efforts to sustain growth after the recession ended last year. The central bank has kept its target rate for overnight loans between banks in a record low range of zero to 0.25 percent since December 2008 and began spending $600 billion to buy Treasuries on Nov. 12 in its second round of so-called quantitative easing.

Sales Accelerate

State and local governments issued $351.7 billion in debt this year, on pace for the most since Bloomberg began keeping records in 2004.

Sales were boosted by the Build America Bond program, an initiative of President Barack Obama that pays state and local issuers a 35 percent subsidy of interest expense when they issue taxable debt. More than $92 billion of the securities have been sold this year, or 26.2 percent of the total. In the six years through 2008, taxable securities comprised 5 percent. The program expires Dec. 31.

Municipal bonds have lost favor as state and local governments face a record $18.5 billion in budget deficits this year, according to a National Governors Association survey. While the U.S. economy is recovering, more than half the states have run out of money in unemployment trust funds, financed by payroll taxes, with the U.S. jobless rate holding above 9 percent. States have borrowed $40.9 billion from the federal government.

Alarm Bells

Harrisburg, the capital of Pennsylvania, is struggling to avoid bankruptcy, and a South Carolina toll road defaulted on its debt. Meredith Whitney, the banking analyst who correctly predicted Citigroup Inc.’s dividend cut in 2008, said in September that the U.S. government will face pressure to bail out struggling states in the next 12 months, joining investor Warren Buffett in raising the alarm about the potential for widespread defaults in the $2.8 trillion municipal bond market.

Investors withdrew $3 billion from open-end municipal bond mutual funds in the week ended Nov. 17, the most in almost 19 years, according to Lipper FMI.

“It’s become a negative-feedback loop,” Thomas Metzold, co-director of municipal investments at Boston-based Eaton Vance Corp., said last week. “Funds have to sell bonds to meet redemptions, putting pressure on prices, causing more redemptions.”

Money managers point to a strengthening economy and recovering tax revenue as signs that municipal yields will fall below Treasuries. California, Texas, Florida and New York, the four biggest states, all added jobs last month for the first time since May.

Concerns Overstated

The gains could help shrink budget deficits that the Center on Budget and Policy Priorities says will likely total $140 billion in fiscal 2012, as new jobholders boost income- and sales-tax collections. States’ tax revenue grew about 6 percent in the three months ended on Sept. 30, the third consecutive increase, Goldman Sachs Group Inc. said Nov. 19.

Concerns about borrowers missing debt payments have been overstated, according to a report by Fitch Ratings on Nov. 16. Investment-grade municipal default rates were as low as 0.04 percent over the past 10 years, the report said.

“While the incidence of default may increase from exceedingly low historical levels, defaults will continue to be isolated situations,” the report said. “There is a long record of governments making difficult choices to maintain budget balance while making full and timely debt service payments even in very stressful financial situations.”

Three-Month High

Ten-year AAA general obligation bond yields reached 2.87 percent last week, according to Municipal Market Advisors data for that maturity. Yields on 10-year Treasuries touched a three-month high of 2.96 percent and were 2.86 percent as of 7:57 a.m. in New York.

Municipals are “a good place to pick up yield,” said Andy Richman, who oversees $10 billion as a strategist in West Palm Beach, Florida, for SunTrust Bank’s private wealth management division. “We don’t think there will be massive defaults.”

The ratio of municipal to Treasury yields rose above 100 percent for about three months starting in September 2002 and April 2003 before declining. In 2003, state and local bonds returned 6.18 percent, trouncing the 2.26 percent gain for Treasuries, according to Bank of America Merrill Lynch indexes.

‘Extremely Low’

“Given the extremely low” Treasury yields, “high quality munis offer a great alternative for a short-term investor looking for yield. Period,” said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York. Pollack said he has been buying munis for clients who usually only hold Treasuries. “Investors are better off in the muni market where you can get yield at more than 100 percent of Treasuries on an absolute return basis with similar credit risk.”

Besides munis being undervalued in historical terms, the world’s biggest money managers say Treasuries are overvalued. Bond investors expect consumer prices to rise 2.16 percent a year, based on the difference between yields on 10-year Treasury-Inflation Protection Securities, or TIPS, and similar maturity Treasuries. That’s up from 1.51 percent in August.

Bill Gross, who oversees the world’s biggest bond mutual fund at Pacific Investment Management Co. in Newport Beach, California, says the 30-year bull market in Treasuries is drawing to a close because yields can’t fall further after the Fed pushed borrowing rates to all-time lows.

Investors who want to add risk and take advantage of the muni premium may purchase two-year California notes that yield 1.08 percent, or more than double the 0.51 percent yield on comparable maturity Treasuries, according to Bloomberg data.

“Treasuries have gotten very expensive,” said Jeffrey Schoenfeld, a partner and chief investment officer in New York at Brown Brothers Harriman & Co., which manages $33 billion in assets. “Quantitative easing has had the effect of pushing down yields tremendously. Now you are better buying munis than Treasuries.”

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