A lot of people I have talked with recently are suggesting that if an investor is looking for more (after tax) yield these days that it might be a good idea to look at the bonds issued by state and local governments.
States, cities, counties school districts, public utility districts, redevelopment agencies and other governmental bodies at or below the state level may issue these municipal securities. The bonds may be a general obligation of the issuer. Or, it could be associated with specific revenues.
The interest income received by investors in these municipal bonds may be exempt from federal income tax and may also be exempt from state income taxes. Markets for these issues may be relatively liquid with a fair amount of daily trading. An investor in such securities should investigate this aspect of the specific issues he or she is interested in.
The reason why people are suggesting that municipal securities may be an interesting investment these days is that they are yielding, on a before tax basis, at an significant spread over risk-free government securities.
This spread has come about in recent months due to the takeover of the city of Detroit by the state of Michigan along with other fiscally troubled cities like Oakland, California.
Just to give an idea of what has happened in the market for municipal bonds lets compare the yield on US Treasury securities with an index prepared by the Bond Buyer (http://www.bondbuyer.com/). The Bond Buyer index for state and local government bonds is made up of twenty issues of general obligation issues with a maturity of at least twenty years. The quality of the bonds are mixed.
I compare this index with an index of yields on US Treasury issues of comparable maturities published by the Federal Reserve System which appear in its weekly H.15 release.
For the week ending October 25, 2013, the spread between the interest rate on the Treasury issue and the Bond Buyer index is 201 basis points, with the Treasury yield trading around 2.55 percent and the yield on municipal securities trading around 4.56 percent…the munis being, of course, tax free.
Michigan took over the finances of the city of Detroit in the middle of March of this year.
In the three months before this takeover the yield spread between the US Treasury bond and the Bond Buyer index averaged 173 basis points.
In the seven months following the takeover, the spread has averaged 199 basis points, right in line with the 201 basis point difference registered in the week ending October 25. In this respect, the market has been relatively stable in terms of the spread investors require between the two issues.
Another way to look at these municipal yields is to compare them with the yield being earned on Moody’s Aaa rated corporate issues. As of the week of October 25, 2013, the yield on the Bond Buyer index was 10 basis points HIGHER than the corporate yield!
For the seven months following the takeover of Detroit, municipal securities, according to the Bond Buyer index traded, on average 10 basis points HIGHER than the Aaa corporate yield.
In the three months directly before the Detroit takeover, the yield in the Bond Buyer index average 18 basis points BELOW the Aaa yield.
The point is that investors looking for greater (after tax) yield these days might look at issues of State and Local governments. The market has seemingly shied away from municipal issues in the wake of the difficulties that some cities are having. As a consequence, for the time being some very good yields might be available.
It does not mean that an investor should not be very careful about the particular issues one might get into. But an opportunity does exist.
One more caveat before I close. If interest rates do rise over the next year as many observers, including myself, believe, the prices of these issues, as I discussed in my post last week, will decline and the investor could be faced with a capital loss.
About John Mason
John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.