Municipal bond investors are piling into Treasuries as state and local government finances worsen and the yield advantage for tax-exempt securities evaporates.
Local government bonds due in three years with AAA ratings yielded 66 percent of similar maturity Treasuries last month, about the lowest level since Bloomberg began compiling the data in 2001. If the ratio moves closer to 60 percent, investors in the 38.3 percent federal tax bracket would lose all the benefits of sheltering income that comes from municipal debt.
Muni bonds are losing favor as state and local governments raise taxes to fund the record $18.5 billion in budget gaps estimated in a National Governor’s Association survey. Increased buying by tax-exempt investors would sustain a rally in short- term Treasuries, already benefiting from demand for a refuge from sovereign credit concerns and rising purchases by banks.
“Treasuries are safer and more liquid investments, especially given the quality issues with many municipalities of late,” said Jeffrey Schoenfeld, partner and chief investment officer in New York at Brown Brothers Harriman & Co., which manages $33 billion in assets. “In this low-rate environment Treasuries can be huge pickup and very good value on an after- tax basis in the shorter-end.”
The Build America Bond program, an Obama Administration plan that subsidizes 35 percent of interest expense for state and local issuers when they sell taxable debt, is also making municipal securities less attractive relative to Treasuries.
Build America Bonds
Almost $80 billion in Build America Bonds have been sold since the program began in April 2009, and taxable bond sales totaled $97 billion, or about 28 percent of long-term, fixed- rate municipal issuance during the last 11 months, data compiled by Bloomberg show. During the six years through 2008, taxable sales made up an average 5 percent of issuance.
More tax-exempt bonds may be replaced with Build America debt, because the federal budget for the fiscal year starting in October calls for an expansion of the program to allow refunding. It also calls for making the stimulus initiative permanent with a lower interest subsidy of 28 percent for new issues beginning Jan. 1, 2011.
Treasuries due in one to three years have returned 0.78 percent since December, after gaining 0.79 percent in 2009, according to Bank of America Merrill Lynch index data. Similar maturity state and local securities returned 0.57 percent this year, extending 2009’s 4.2 percent gain.
Relative Returns
Government securities fell last week after a Labor Department report showed payrolls dropped by less-than-forecast 36,000 in February. Two-year note yields increased 4 basis points to 0.85 percent.
Municipal debt became more expensive as investors bought longer-maturity debt with money stored in short-term tax free money market accounts that yielded as little as 0.02 percent. Assets in the funds dropped by $148.76 billion from the record $528.36 billion in August 2008, according to iMoneyNet of Westborough, Massachusetts.
“Demand for munis is mostly coming from retail investors who have been sitting on a mountain of cash and wondering what to do with it,” said Christine Todd, a managing director and head of the group that oversees $26 billion in tax-sensitive fixed-income portfolios at Standish Mellon Asset Management Co. in Boston. “AAA munis are rich versus Treasuries.”
Baltimore County, Maryland’s AAA rated general obligation bond due in three years yielded as little as 58 percent of comparable Treasuries last week, according to Bloomberg data. The ratio of AAA rated Arlington County, Virginia, debt due in three years dipped as low as 50.7 percent last week, according to Bloomberg data. That means that buyers would be better off buying Treasuries even if they’re in the highest tax bracket.
‘Great Opportunity’
“Most people with wealthy clients think about taxes first, and that usually means munis, even when munis are overvalued,” said Jonathan Lewis, founding principal of New York-based Samson Capital Advisors LLC, which manages more than $4 billion. “Right now there is a great opportunity to go up in quality and increase liquidity by building allocation in Treasuries.”
Municipal bonds may get even more expensive with a proposal in Congress by Oregon Democrat Ron Wyden and New Hampshire Republican Judd Gregg seeking to replace the tax exemption for state and local bonds with a more limited tax credit.
“Supply concerns will continue to be the major issue, even as quality concerns are not emerging to be real issues,” said George Friedlander, municipal strategist for Morgan Stanley Smith Barney in New York. “Add to that the prospect of the possibility for Congress ending tax exemption and it points to more demand for munis going forward. There is still room for munis to get richer.”
Economic Outlook
Even if municipal yields fall, investors can still benefit by switching into U.S. government debt given the relative low level of interest rates and slow economic recovery, said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth management unit in New York.
Federal Reserve Chairman Ben S. Bernanke, who slashed the central bank’s target rate for overnight loans between banks to a range of zero to 0.25 percent in December 2008, has flooded the economy with more than $1 trillion in the largest monetary expansion in U.S. history.
In his semi-annual testimony to Congress last month, Bernanke reiterated that rates will remain low for “an extended period” because the economy’s “nascent” recovery isn’t strong enough to bear higher borrowing costs.
Market Performance
Shorter-maturity Treasures are outperforming longer-dated debt with the Fed in no hurry to raise rates and investors’ concern increasing that inflation will accelerate because of the record borrowing and stimulus measures. Yields on 10-year notes rose to a record 2.94 percentage points more than two-year notes on Feb. 18, and were 2.79 percentage points higher on March 5.
For all the concern about a record federal budget deficit and the rising supply of Treasury debt, U.S. bonds are the place to be so far in 2010, with returns topping equities and commodities. Bank of America Merrill Lynch’s U.S. Treasury Master Index has increased 1.56 percent, compared with a gain of 0.17 percent for the MSCI World Index of stocks and a 0.33 percent increase in the Standard & Poor’s GSCI Index of 24 raw materials.
“Smart investors are doing the math by buying short-term Treasuries, which are giving more after tax returns and adding quality and liquidity to their portfolio,” said Deutsche Bank’s Pollack. “A combination of extremely low rates, lack of muni supply and the prospect of higher income taxes are making munis look extremely rich. If ratios go lower the after tax return will still be there.”
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