Munis: What the Naysayers Don't Know

Choose wisely, buy them direct, and you'll leave Treasuries in the dust

Going by the headlines, you might think municipal bonds would be the last thing to buy today. Don't believe it. Munis are offering the best deals in years. Tax-exempt, top-grade AAA 10-year muni issues now yield about half as much again as government bonds with similar maturities after taxes, following the huge bull run in Treasuries. Assuming 38% state and federal taxes, their current 2.8% yield compares with 1.9% after tax from Treasuries. Before taxes, munis yield nearly as much as Treasuries -- 92% of their return, vs. 75% in 1997. And they're still a lot more rewarding than dividend-paying stocks, which yield just 1.4% on average, even after the latest tax cuts.

So why isn't the news for munis as bad as some people feared after President Bush's tax cuts? They worried that lower federal income-tax rates would penalize tax-exempt munis and throw the advantage to the taxable bonds that compete with them. But states and cities are busy raising their own income-tax rates, thus restoring most of munis' tax advantages. And the dividend-tax cut, which makes stocks more attractive, doesn't affect munis much because most investors compare after-tax yields from munis to other bonds, not to stocks, says George Friedlander, muni strategist at Smith Barney.

Likewise, the gaping state and local revenue shortfalls won't hit munis as much as you might expect. With few exceptions, state and local governments are required to balance their budgets every year. So they're not allowed to cover their operating deficits by selling more bonds the way the federal government does. Indeed, cities and states are likely to issue fewer bonds than usual because repayments come out of the annual budget, and governments often hesitate to issue bonds for capital projects when they see tax revenues slowing.

What's more, because cities and states can't issue bonds willy-nilly, investors don't face a high risk of losing money from a default. In fact, from 1970 to 2000, credit losses on munis were lower than even those on AAA-rated corporate bonds, according to a Moody's Investors Service (MCO ) study published last November. A study done two years ago by Standard & Poor's credited New York City's financial crisis of the 1970s with encouraging more controls on state and local spending.

Still, munis hold pitfalls for the unwary. Issues backed by a single source of revenue can prove dangerous. For example, airport bonds serviced from fees paid by airlines have plunged in value as carriers such as US Airways and United Airlines (UAL ) landed in bankruptcy court. Bonds for ill-conceived toll roads, amusement parks, and aquariums have also bombed. This year, tobacco-settlement bonds -- munis backed by payments cigarette makers have pledged to cities and states -- have fallen in value as investors judge that court rulings against the companies weaken their ability to pay. And when interest rates rise, the value of munis -- like other bonds -- will fall. Says Bradley C. Gewehr, muni strategist at UBS: "That day of reckoning is still out there."

Muni buyers should bear in mind two other caveats. Buy munis direct, rather than through a mutual fund, so you'll be assured of getting all your capital back at some point. Also, avoid munis with long maturities that could fall sharply in value if interest rates rise. "If you're looking for safe income and getting your principal back [within 10 years], munis are still the instrument of choice," says Smith Barney's Friedlander. "If you're talking [riskier] 30-year munis against stocks, munis are a tougher challenge than before the tax bill," he says.

Prudent investors will stick with munis that are rated by credit agencies and backed by either the government itself or by revenues from essential services, such as water or electricity. That still leaves plenty of scope to move down the credit scale safely and pick up extra yield. General obligation bonds rated single-A now yield about 0.5 percentage points more than triple-A bonds. This is a spike from the traditional 0.3 percentage points. But in these days of low returns, every little bit helps.

By David Henry

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