It's That Time of Year: Municipal Bonds Yield More than Treasurys

In the last few years one of the more predictable patterns in the municipal bond market occurs at year-end.

Normally, of course, municipal bonds yield less than comparable maturity Treasury bonds because of their tax-free nature. However, several times over the past few years we have seen situations where as we approach the end of the year that AAA-rated municipals are yield more than comparable Treasury, setting up a nice buying opportunity.

Here's why: this phenomena occurs because, for whatever reason, municipalities wait until year-end to issue a large amount of debt. However, this is also the same time of year when some of the largest buyers of municipal bonds - namely, insurance companies and banks - begin to reduce their investment activity in preparation for year-end. This imbalance - lots of supply, less demand - causes municipal yields to rise.

After year-end, going into the first quarter, supply pressures are lessened, and municipals revert back to their normal relationship relative to Treasurys, i.e., yielding less. Hence the opportunity.

This year the situation has been exacerbated by the possible expiration of the Build America Bond (BAB) program. BAB's were introduced a couple of years ago by the Obama administration as a wait to spur infrastructure spending as well as creating jobs. The interest paid on BAB is subsidized by the federal government (usually the feds pay 35% of the interest tab), making it attractive for municipal governments.

However, at this writing, it is not clear whether this program will be extended into 2011, so there has been a rush by municipalities to issues BAB's. When you throw on the usual year-end spate of new municipal issuance, municipal yields now yield more than Treasurys.

Now I can hear some of my readers say: Not so fast. Municipal credit concerns are growing, and a number of analysts are warning of municipal defaults (which historically have been quite low, by the way).

I don't disagree: I too expect that we will see weaker municipal credits have a difficult time, and possibly try to default. However, unless you are forecasting financial Armageddon, I have a hard time seeing any state defaulting. Moreover, "essential service" bonds like those connected with water and sewer projects are also unlikely to default. Yet even these credits are offering attractive relative yields these days, which to me is a chance to add return to portfolios without adding much risk.

I have attached a link to a Bloomberg story discussing the current market situation.


Munis Yield More Than Treasuries as State Funds Wane (Update4) - Bloomberg.com