Muni Bonds: Time to Dive In?

These bonds have gotten cheaper compared with Treasuries—and the fatter yields present tempting opportunities for investors

by David Bogoslaw

Municipal bonds are traditionally one of the safest havens in times of economic uncertainty. But lately, investors have been treating them like just another distressed asset class. Less than six months ago, munis may have reached their cheapest levels since just after the Civil War, says Ying Chen Li, muni strategist in JPMorgan Chase's (JPM) fixed-income department. In the latter half of the 1860s, defaults on state government-issued bonds surged not only because of the ravaged economies of the Confederacy but also because of a clause in the 14th Amendment to the U.S. Constitution that prohibited repayment of public debt issued to aid the rebellion against the Union.

In 2008, the subprime crunch has taken its own toll. The Municipal Bond Credit Derivative Index, launched in May, partly in response to the credit crisis, is trading at levels that imply a greater than 30% probability that individual states, such as California, will default on their bonds over the next 10 years, says Ying.

"That just doesn't make sense at all," he says. "There will be some defaults at the local government [level], but at the state level, it's unimaginable."

One measure of how big a bargain muni bonds are: The yield ratio of five-year, triple-A munis to five-year Treasury notes has averaged 80% over the past 10 years, says Ying. But in late February and early March, the ratio topped 150%—that is, the yield on munis was nearly double its normal level. Credit spreads—the yield difference between munis and risk-free U.S. Treasury bonds—have narrowed somewhat since the weeks of heightened nerves that preceded the collapse of Bear Stearns, he says, but not by much. Ying says the yield ratio now is closer to 90%, while the ratio for 30-year, triple-A munis is 105% of 30-year Treasuries, compared with an average of 94% over the past decade.

Domino Effect

The plunge in muni bond values was prompted mainly by rating agency downgrades of such bond insurers as Ambac Financial Group (ABK) and MBIA (MBI). Their insurance used to guarantee that munis got a triple-A rating—and used to give investors peace of mind about the credit risk they were buying. No more. The insurer downgrades triggered lower ratings for the bonds the companies insured. In turn, the lower ratings on the munis led to forced selling of bonds by institutions not permitted to own debt below a certain rating. The result: a glut of munis on the market at big markdowns.

Munis are always recommended for their evergreen tax advantages, which are expected to increase as the Bush tax cuts expire in 2010 and the top tax rate reverts to 39.6%, no matter which party wins the White House. But the current environment has created new possibilities for investors who aren't easily frightened by less than top-notch credit ratings, especially if they understand that the bond insurers' fall from grace was linked to their coverage of riskier mortgage-backed bonds, not anything related to the muni market.

In the market turmoil—particularly after the auction-rate securities market froze up—"we saw spreads [vs. Treasuries] widen on A and BBB credits, mainly due to supply pressure,"Thalia Meehan, portfolio manager of tax-exempt products at Putnam Investments, wrote in an e-mail message. "We viewed this as an opportunity to [buy higher-yield muni bonds] without taking undue credit risk."

She said her team plans to add bonds opportunistically from issuers with ratings below triple-B, or below investment grade, as they see acceptable credits at attractive prices.