Another Munificent Year For MunisKelley Holland
Investors who bought municipal bonds at the beginning of 1993 can pat themselves on the back. They probably had a banner year. And the way 1994 is shaping up, they may deserve another pat a year from now, if they keep their holdings. Why? A looming federal tax hike, a decline in supply, and high muni yields relative to Treasury securities, all of which should push up prices.
Higher taxes--no surprise--continue to be the key factor. In 1993, they overwhelmed such bearish forces as $290 billion in new muni bonds issued by cities, states, and public authorities, surpassing the record $232 billion in 1992 (chart). Similarly, a spate of muni-market scandals involving questionable political contributions by Wall Street firms failed to deter buyers. In 1993 through Dec. 10, muni bonds had a total return of 13.5%, according to Applied Municipal Network.
ROSY OUTLOOK. In 1994, buyers are expected to continue scrambling to put their money in one of the last remaining tax shelters. Even though the new federal taxes became effective at the beginning of 1993, few taxpayers increased withholdings from their 1993 paychecks. That means they stand to get hit with big tax bills come Apr. 15--and they will probably start thinking harder about tax-exempt investments. "When they write out that check, that's when they'll change their [investment] allocation," says Pamela Hunter, a vice-president at Chase Manhattan Bank.
Adding to the rosy outlook is the prospect of fewer new issues in 1994. Thousands of municipalities in 1993 issued low-coupon bonds to refinance higher-coupon issues. If rates stay stable or increase, the refinancing will slow. Ann C. Stern, chairman and chief executive officer of Financial Guaranty Insurance Co., a muni insurer, expects $200 billion or less in new issues in 1994.
Investors getting into the market now should also find prices on their holdings rising as yields fall relative to T-bonds. Yields on high-grade tax-exempt bonds are now within only 0.2% of Treasury bonds of the same maturity, so the aftertax yield of the munis is much higher. With top tax rates increasing to 39.6%, munis would have to yield close to 0.4% less than comparable Treasuries for the aftertax return to be the same. If the spread between muni and Treasury yields were to widen to that extent, it would produce a substantial rise in bond prices.
High-grade bonds are currently the best bet. Single-A bonds are yielding just 0.1% more than comparable insured triple-A securities. "In the muni market, you really don't get paid for taking a big chance," says Robert Godfrey, executive vice-president of the Municipal Bond Investors Assurance Corp.
You don't get paid for going long, either. If you want to pick up some yield but limit your exposure to a possible rise in interest rates, stick to 7- to 10-year bonds. James J. Cooner, a senior vice-president at Bank of New York, notes that there's little increase in yield between 10- and 30-year bonds. And because longer-term bond prices tend to fall more than short-term ones when interest rates rise, long-term bonds are riskier. "The biggest risk in the municipal bond market today is investing in long-term bonds at the bottom of the interest-rate cycle," he says. The same is true for long-term muni-bond funds.
CALIFORNIA COMEBACK. As for regions to consider, a number of portfolio managers are turning more bullish on California, whose bonds have gotten beaten up--and perhaps too beaten up--because of worries about the state's economy. "We look at a state like California just as we looked at Massachusetts" a couple of years ago, says Richard J. Moynihan, a portfolio manager who oversees Dreyfus Corp.'s $30 billion in tax-exempt funds. Moynihan also views New York as a "tried and true" issuer, and says Dreyfus bid for part of a $702 million bond issue on Dec. 8 from the state's Local Government Assistance Corp.
General-obligation bonds around the country also look good. General tax receipts that back GO bonds should increase as the economy improves, says Chase's Hunter, who manages $2 billion in tax-exempt funds. She is buying Florida bonds because the state may soon raise its tax on intangible assets, thereby improving its fiscal health.
Muni bonds all over the country should perform relatively well, however. Tough times for taxpayers generate one positive side effect--a boon to muni-bond holders.