Tax-Exempt Yield Advantage Lures Taxable Investors: Muni Credit

Tax-Exempt Yield Advantage Lures Taxable Investors
Ten-year municipal yields averaged 101 percent of those for Treasury notes in August, according to data compiled by Bloomberg, and were 105 percent yesterday. The ratio touched 109.5 percent in the month, the highest since April 2009. Photographer: Andrew Harrer/Bloomberg

A flight to U.S. debt amid signs of an economic slowdown put tax-exempt yields at their highest premium to Treasuries in more than two years last month, creating a buying opportunity that could extend into 2012.

Ten-year municipal yields averaged 101 percent of those for Treasury notes in August, according to data compiled by Bloomberg, and were 105 percent yesterday. The ratio touched 109.5 percent in the month, the highest since April 2009.

The yield advantage has lured taxable-bond investors into munis, said Peter Hayes, a managing director with New York-based Blackrock Inc., which owns $98.2 billion of municipal bonds.

“We have been buying and we continue to look,” Hayes said. “If a particular credit comes out that we happen to like and it’s priced attractively on a relative basis, we’d still find some value and a reason to put it in our taxable funds.”

Some A and AA rated tax-exempts in the health-care, education and utility categories, as well as prepaid gas bonds, can produce ratios of more than 100 percent, Hayes said.

“If you were to compare them just to Treasury rates, on a relative basis they would look very, very cheap,” he said. “They would be well over 100 percent, maybe 130 percent or 140 percent.”

Treasury yields fell faster than those of municipals last month as investors sold stocks and bought bonds after Standard & Poor’s downgraded the U.S. credit rating and amid reports of a slower economic recovery. The Bloomberg Consumer Comfort Index released yesterday showed sentiment slumped to the second-lowest level in two years.

30-Year Yields

Top-rated 30-year tax-exempt bonds offered an average yield of 3.93 percent in August, 28 basis points more than the average 30-year Treasury yield, according to Bloomberg data. The ratio between 30-year tax-exempt debt and 30-year Treasuries averaged 108 percent in August and was 110 percent yesterday. It reached 113 percent in the month, the highest in almost a year.

In addition to higher yields than Treasuries, municipals provide tax-free earnings, said John Hallacy, head of municipal research at Bank of America Merrill Lynch in New York.

“It’s a relative world, and if the Treasuries are so much lower and you can get munis at 150 percent, why not buy?” he said. “If they’re tax exempt, that’s even better.”

The higher muni-to-Treasury ratio could continue through the November 2012 presidential election because the Federal Reserve has said it will hold its benchmark interest rate at zero until mid-2013 and investors will wait to see if federal income-tax breaks expire at the end of 2012, Hallacy said.

Persistent Condition

“Even though we’re not always trading one to one perfectly with Treasuries, it stands to reason that this might persist for quite some time,” he said.

Municipal securities have returned 7.52 percent so far this year, according to the Bank of America Merrill Lynch Municipal Master Index, which measures interest income and price appreciation. Treasuries have returned 7.08 percent and corporate bonds have returned 5.77 percent.

Investors thinking about tax-exempts shouldn’t wait because the spread between yields will correct itself, said Chris Shayne, senior market strategist at Mill Valley, California-based BondDesk Group LLC, a bond-trading platform for individuals.

“Either Treasuries will come up or munis will come down, but the volatility that is creating this additional spread will dissipate,” Shayne said. Investing in tax-exempt debt now is a “defensive buying opportunity,” he said.

Municipal issuers are scheduled to borrow $3.7 billion next week after $1.9 billion this week, the lowest for a week before Labor Day in at least eight years, Bloomberg data show.

Value Ahead

Issuance will probably increase though the latter part of the year and offer “a tremendous amount of value,” said Peter Demirali, who manages $350 million of taxables at New Jersey-based Cumberland Advisors.

“We don’t think that this will last forever,” Demirali said of muni yields higher than Treasuries. “Ultimately, those ratios will come in considerably. On a total-return basis, it’s the trade to make.”

Following is a description of a pending sale of municipal debt:

NEW YORK STATE THRUWAY AUTHORITY, which oversees a 570-mile toll road system, will sell as soon as next week $350 million of personal-income tax revenue bonds to finance highway and bridge projects. The bonds are rated AAA, Standard & Poor’s highest grade. Siebert Brandford Shank & Co. LLC will lead banks on the deal. (Added Sept. 1)

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