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Yields Lowest in 45 Years Still Cheapest Since ’96: Muni Credit

Tax-exempt municipal bonds are at their cheapest compared with company debt since at least 1996, signaling that local-government securities offer value even with yields close to the lowest since the 1960s.

Corporate bonds, which are taxable, have outpaced city and state debt as fixed-income buyers sought shelter from financial-market turmoil. As a result, the extra yield investors typically demand to buy 15-year company bonds instead of similar-maturity tax-exempts has shrunk to less than 10 percent of the 10-year average, Bloomberg Fair Valuation Indexes show.

For Charles Breunig, who helps manage $3 billion of munis at American Family Mutual Insurance, the disappearing yield gap has been a sign to shift into tax-exempts from taxable munis.

“Tax-exempts offer better protection” if interest rates start to climb, he said in an interview from Madison, Wisconsin. “We want to maximize our relative performance.”

As the extra yield on corporate bonds over tax-exempts has declined, so has the cushion debt-holders get against a historically higher default rate for company securities. Only 0.13 percent of municipal bonds rated by Moody’s Investors Service defaulted from 1970 to 2011, compared with more than 11 percent of company borrowings.

Defaults Down

Defaults are down for local debt as tax revenue has rebounded following the recession that ended in 2009. Forty-two municipal issuers defaulted for the first time this year through July 31, below the average of 76 for the same period the past two years, according to Municipal Market Advisors, a research firm based in Concord, Massachusetts.

Interest rates on 20-year general obligations sank to 3.61 percent last week, approaching the 45-year low of 3.6 percent set in January, according to a Bond Buyer index.

Corporate yields have dropped even faster amid a Treasuries-led rally. Fifteen-year company bonds rated A yielded 3.21 percent as of July 30, down from this year’s high of 4.15 percent in March, Bloomberg Fair Valuation Indexes show.

The company interest rate is about 0.1 percentage point above munis rated AA-, two steps higher. The spread, which has fallen from 0.73 percentage point in February, has averaged about 1.14 percentage points in the past decade. On July 12, the muni index even yielded 0.05 percentage point above the corporate benchmark, the cheapest tax-exempts have been since the company index began in 1996.

Compensation Question

The slimmer yield gap may not make sense, given that economic growth has slowed, potentially crimping company profits, while credit-rating downgrades surpass upgrades. Standard & Poor’s lowered the marks for $2.16 trillion of corporate debt worldwide in the first half of 2012 and raised $707 billion.

“Given the slowdown in the global economy and tight spreads, corporate investors should ask themselves if they are being fully compensated,” said Gary Pollack, who manages $12 billion as head of fixed-income trading at Deutsche Bank AG’s private-wealth unit in New York. “And if the answer is no, they should be buying municipals.”

Pollack said he’s directing new cash to munis rather than corporate debt.

For buyers paying the highest tax rate, muni yields become even more attractive. The 3.11 percent yield on AA- munis maturing in 15 years is equivalent to a 4.8 percent taxable rate for investors in the top income bracket.

Similar Yields

In an example of how company and tax-free debt are offering similar yields, International Business Machines Corp., the world’s largest computer-services provider, on July 25 sold 10-year bonds rated AA-, Standard and Poor’s fourth-highest grade, to yield about 2.05 percent. The same week, Regents of the University of California sold tax-exempts with a similar rating and maturity to yield 1.97 percent.

City and state debt is also on a pace to beat Treasuries and corporate bonds for a second-straight year when adjusting for volatility.

Munis have earned about 3 percent this year through July 30 after accounting for trading swings, according to data compiled by Bloomberg and Bank of America Merrill Lynch. Company securities have earned 2.1 percent by that measure, compared with about 0.7 percent for Treasuries.

Breunig said he expects muni and corporate yields to revert to their historical relationship when fixed-income interest rates climb. The yield on the benchmark 10-year Treasury fell to a record 1.379 percent on July 25.

“You don’t have to give up anything” in terms of yield, he said. “And you have potentially great outperformance by tax-exempts going forward in a rising interest-rate environment.”

Following are pending sales:

NEW YORK CITY TRANSITIONAL FINANCE AUTHORITY plans to offer $1.55 billion of subordinate debt starting as soon as Aug. 6, according to the city’s Office of Management and Budget. The sale, backed by tax receipts, includes $850 million of tax-exempt bonds that will go toward financing capital projects and refunding. The agency also plans to sell $350 million of taxable bonds, as well as $350 million of tax-exempt, variable-rate bonds set to price Aug. 28. S&P rates the authority’s subordinate credit AAA. (Added Aug. 1)

CALIFORNIA STATE UNIVERSITY plans to sell about $365 million of revenue bonds as soon as this week, according to data compiled by Bloomberg. A portion of about $17 million will be taxable. Moody’s rates the debt Aa2, third-highest. (Updated Aug. 1)

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