A Comeback for Munis

The Great Recession may be winding down, but state and local government finances continue to deteriorate. California, the eighth-largest economy in the world, keeps treading on the edge of fiscal disaster. Nine other states aren't in much better shape, according to a recent study by the Pew Center on the States. Even after taking into account aid from Washington, state governments face a combined projected budget deficit of $350 billion over fiscal years 2010 and 2011, according to the Center on Budget & Policy Priorities.

Investors are reacting by snapping up tax-exempt bonds. No, they haven't taken leave of their senses. The average long-term return for tax-exempt bonds is 4% to 5%. But last year was miserable, with high-quality munis falling by 5% and more risky munis by 20%. This year the market has rebounded sharply. Long-term muni bond funds are up 17% as of Dec. 3, according to Morningstar (MORN). Intermediate muni funds have risen by almost 12% over the same period and short-term munis by nearly 6%. "In the future, returns should be more in line with historic norms," says Hugh McGuirk, who heads T. Rowe Price's (TROW) muni team.

This nervous normalcy in the muni market is largely the reflection of a new balance between forces of supply and demand. The popularity with state and local governments of Build America Bonds—taxable securities with interest payments subsidized by the federal government—is slashing issuance of long-term tax-exempt securities. The demand for tax-exempts is up, too. The new money flowing into tax-exempt mutual funds this year is on track to reach some $70 billion, well above the previous yearly record of $38 billion in 1993.

DOWNGRADE THREATOne reason for the embrace of munis is an expectation that taxes will go up. Also, yields are attractive relative to comparable Treasuries, especially for those in top tax brackets. For instance, the dividend yield on the Vanguard Long-Term Tax Exempt (VNJTX) fund is 4.43%. The yield on the Vanguard Long-Term U.S. Treasury (VUSTX) fund is 4.0%. Yet an investor in the 35% tax bracket would need the taxable-equivalent yield of 6.82% to best the tax-exempt fund. For a resident of California, with its 9.3% upper-income tax bracket, the taxable-equivalent yield on Vanguard's California fund, the Vanguard CA Long-Term Tax-Exempt (VCITX), is 7.43%.

Still, what about those yawning budget deficits? State government defaults are rare (Arkansas was the only state to go into default during the Great Depression). A number of states could have their debt downgraded this year, though—Illinois, in fact, was downgraded from A1 to A2 on Dec. 7.

The muni bond has fundamentally changed, too. In 2007 half the market was backed by specialized insurance companies. But muni bond insurance has almost disappeared, a casualty of the credit crunch. "We now look a lot like the corporate bond market," says John Cummings, head of the muni bond desk at Pimco. "We are a credit market. People now have to know that not all AA-rated and A-rated bonds are the same."

Investors are sensibly seeking a measure of safety by sticking with high-quality general obligation bonds, which are backed by the taxing power of the issuer. When buying revenue bonds, which are supported by fees, investors are seeking out bonds backed by revenues from so-called essential services, with the classic examples being water and sewer bonds. Leslie Beck, a certified financial planner with her eponymous firm in Palo Alto, also considers revenue bonds issued by the Los Angeles and San Francisco airports as being backed by an essential service, but would steer clear of secondary airports such as nearby Reid-Hillview Airport of Santa Clara County.

Munis won't be boring for awhile. But after the turmoil of the past few years, a nervous normalcy sounds pretty good.

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