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Did the thought occur to you this week, "I need a safer place for my money?"
Stocks obviously are suffering. And with interest rates rising, the past year has been painful for bondholders. But to Mary Miller, a T. Rowe Price (TROW) managing director responsible for investing $7.2 billion in municipal bonds, that signals that bonds are a less risky, more attractive asset.
If rates keep increasing, bond investors' pain won't ease. And munis, or municipal bond mutual funds, aren't for everybody. But if your federal income tax bracket is 28% or higher, you should pay attention. Intermediate-term, AAA-rated munis now are paying more than 5%, the equivalent of more than 7% on an aftertax basis.
To survey the territory in muni-land, I reached Miller by phone in Baltimore, where she joined T. Rowe Price in 1983. She's a good source on the subject, because over the years, the funds she runs have enjoyed higher-than-average returns at lower-than-average risk. Here are edited excerpts of our discussion:
Q: How would you describe the current muni market? An essay question, I know.
A: At the bottom line, I'd have to say it's attractive.
Q: Why?
A: Well, we've had a kind of ugly last year, with rates rising about 100 basis points [one basis point is one-hundredth of a percentage point] in 1999, and then we had a nice first quarter, with a rally in February and March. We've given back a fair amount of that in April and May.
Q: And now?
A: Rates are at a level that I think [is] pretty attractive for taxable investors. I think that with all the choppiness of the market, some good things have happened, with risk being better-priced. I think we've seen yield spreads for very-high-quality and very-low-quality bonds widen out over the last year -- and that's a good thing.
Q: Why?
A: Because in 1998 and maybe early into '99, the market was not correctly pricing lower-quality bonds, so the spreads were very narrow.
Q: So investors now are making better distinctions between low-credit-quality and high-credit-quality municipalities?
A: Yes. That's a healthy thing for the market. Risk is being priced better, and with rates being maybe 100 basis points higher for an investor, that's maybe a 20% increase in income, a move from 5% to 6% yield. If you're buying today, you're getting a significantly bigger income.
Q: What kinds of municipal bonds will pay 6% today?
A: Harvard University is going to price a long bond. It will have a final maturity probably of 2035. The early talk on that is it will be a 6% to 6.05% yield. And that's a AAA credit...
Q: Is there any reason why a taxable investor in the 28% bracket or higher needs to buy a taxable bond as opposed to something paying almost 6% tax-free?
A: Normally, what we compare municipals to [is] the Treasury market. And right now, a AAA long-term muni bond, again sticking to 30 years [in maturity], is yielding 97% of Treasuries. So there is no reason why a taxable investor in the 28% bracket considering buying Treasuries or munis shouldn't buy municipals. We're almost giving it to you even.
Q: I see. You get an equivalent pretax yield, plus the tax break.
A: On the other hand, on a corporate bond, yields have widened out dramatically vs. Treasuries. A 30-year municipal bond today is yielding about 72% of a corporate index. So there, it's a more break-even choice for a 28% [tax bracket] investor... There are other choices out there for investors, and corporate bonds are very cheap.
Q: How do you assess the credit trends for the municipals market? With tax revenues very high and governments flush, is this as good as it gets on the fiscal side?
A: We may be close to as good as it gets. If it gets much better, the taxpayers are going to start demanding some tax cuts. Over and over again, we're seeing the story that the tax coffers are full, the states have underestimated their revenue growth, and that budget surpluses are big. In general, governments are doing the prudent thing in trying to sock some away for a rainy day or a less strong time in the economy.
Q: What if the economy turns sour?
A: It takes a while for that to feed into the numbers, particularly for state
and local governments. Property taxes are a big part of their revenue stream, and the property-tax base tends to adjust more slowly than the economy might adjust. Sales tax revenues will be more sensitive. Income taxes you may see a one- or two-year lag before that really begins to hit.
Q: But how quickly does the municipal market react?
A: I've been here for 17 years, so I've seen a couple of cycles. Initially, if you think the economy is slowing down, you see investors go more toward high quality. They're afraid that the spreads will widen, that the lower-quality bonds will have to command higher rates. Secondly, you'll begin to see a shift away from the general obligation tax-backed credits toward what we refer to as "essential-service" bonds, maybe water and sewer, which are less sensitive to economic cycles.
Q: I see.
A: I would step back from that and say that we've already seen a fair amount of spread widening in a very strong economy. So I don't know if that will be so pronounced if we do go into a downturn.
Q: Is the flow of municipal bonds increasing with the flush times?
A: No. In fact our supply this year is down through April, I think 29%. Why is that? Partly because we're in very good economic times. The coffers are full, and some places have just opted to pay out of current revenues as opposed to borrowing. The state of Maryland, for example, cancelled its general-obligation debt sale, which it has held without interruption for as many years as I can remember. They had, I think, a $150 million sale scheduled for February, and they said, "You know what? We don't need to do this."
Q: Is there any maturity that offers particularly good value?
A: Let me give you some numbers. In five years [maturity] today, a AAA-level is 5.10%. In 10 years, it's 5.32%. In 15 years, it's 5.65%. So you're not giving up as much as you normally do [with shorter maturities].
Q: So, everything else being equal, stay short?
A: I think until the Fed is done with their work, I would probably stay inside of 15 years, which is where individual investors usually gravitate. But the average life of a
long-term municipal bond fund is probably between 15 and 20 years. If you're an absolute yield buyer, then the long end is attractive at 6%-plus.
Q: Are your funds seeing money flow in or out?
A: It has been pretty negative. Pretty steady outflows this year.
Q: Retail investors aren't seeing the value?
A: Well, what I'm seeing and feeling and hearing is that retail [investors] are buying bonds directly, but they have not been putting money into mutual funds.
Q: How much money does an individual need to build a portfolio of munis directly, instead of buying a fund?
A: There are two parts of the question. The minimum size you can buy in a muni bond is usually $5,000 in one name. And I would suggest that to be fully diversified, you should have at least 20 names. That's $100,000.
Q: I see.
A: The other part of the question is how do you transact efficiently? And buying lots of $5,000 is very inefficient because there's a very high cost. To be efficient, you should have $20 million and be buying in lots of $1 million and getting institutional-type pricing. Maybe I'm getting on a soap box here.
Q: Go ahead. Climb up.
A: The individual does not appreciate some of the efficiencies they gain in a mutual fund. When I hear people say, "Just buy bonds directly. Buy and hold them. That's a lot better than all the cost of a mutual fund" -- I don't think our costs are very high.
Q: What would it cost to buy directly?
A: One to three percent. The dealer is going to sell it with a markup of one to three points.
Q: And dealers are under no obligation to disclose that.
A: There's more disclosure than in the past. There's a site now, called MSRB -- the Municipal Securities Rulemaking Board. They require dealers to post trades. And if an individual has the wherewithal to go find that Web site and look, they'll see some of the pricing. They'll be amazed. You would be amazed to see the difference. You'll see bonds that traded, and you'll see the same name trading again at a wildly different price.
Q: What else do amateur investors need to know about munis now?
A: Investors are looking backward at a period of rising rates and negative returns for the last year. But I would focus on the heightened income. Every time rates go up by a full percentage point, there's less risk in the market. I don't know that the Fed is done with its work. But when they finish raising short-term rates, the economy probably will have slowed, and that's probably a good time to be holding bonds.
Barker covers personal finance in his weekly column, The Barker Portfolio, for Business Week from Melbourne Beach, Fla. And he appears every Friday on Business Week Online EDITED BY DOUGLAS HARBRECHT
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