Municipal bonds beckon -- or not (UPDATE)

There’s a very insider-ish story about municipal bonds running on Bloomberg today. The short version is that hedge funds and Wall Street firms have been dumping muni bonds lately, pushing prices down and yields up. Connecticut sold a 10-year deal the other day at 3.66%, or 95% of the yield of the 10-year Treasury bond that day. But an investor pays no federal or state income tax on the Connecticut bond. That means the after-tax yield for someone in the Fed’s 28% bracket is more like 5.08%, not even including the state tax avoidance. The story focuses on how this is bad for municipalities that have to pay more interest and underwriters who are seeing issuance drop.

But for investors, there’s a strong “buy” signal here. Rates have ticked up since that December 3 Connecticut deal. Bloomberg reports that the average yield for AAA-rated, 10-year muni bonds is now 3.92% equivalent to 5.44% after-tax for someone in the 28% bracket. That 3.92% represents 96% of the yield of a 10-year U.S. Treasury note. Historically, munis don’t trade at that lofty level for too long. There’s now a bunch of exchange-traded funds for investing in muni bonds, making it easier than ever to play for a recovery.

Back in September, I mentioned two of the most basic (and similar) muni ETFs: Barclays’ iShares S&P National Municipal Bond Fund (Symbol: MUB) and State Street’s SPDR Lehman Municipal Bond Fund (TFI). Since then, MUB has gained almost 2% in price and paid dividends equal to another percentage point of tax-free income. TFI has gained almost 1% in price and paid a tax-free monthly dividend of almost 4% annualized. Since then, other choices have come to market as well. Seeking Alpha wrote about some of the newer stuff last week.

Conditions could get even more extreme as year-end approaches. Typically, lots of individual investors sell muni bonds in December to harvest tax losses, causing a further price slump. So with a host of short-term factors pushing down prices on munis, ‘tis the season to find investing opportunities.

UPDATE: Then again, maybe not. Word on the wire is that Standard & Poor’s slapped a negative outlook on the AAA ratings of top muni bond insurers MBIA Inc. (MBI) and Ambac Financial Group Inc (ABK). Though the worries have little to do with munis — S&P pointed to structured investments related to subprime that the two insurers backed — untold billions of tax-free bonds trade on the basis of MBIA and Ambac’s good name. A possible loss of the AAA can’t be good for munis. If you were buying uninsured munis, however, the buying opportunity might be enhanced by this news.

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