Here we go again. Just as we hit the one year anniversary of Meredith Whitney’s famous, or more accurately infamous, muni bond call a new muni bond scare has surfaced. This time its the potential change to municipal bond’s tax status. Lets take a look at this latest fear and see if it is justified.
First, I can’t let this chance pass to comment on last year’s muni bond scare. Back in January of this year I wrote a post about the sell off in munis in response to Whitney’s call. I noted that the sell off seemed unwarranted based on fundamentals. Well, lets just say its been a nice year for munis, up about 11% in price alone, as the chart below shows. What does Whitney say now? She is sticking to her guns. There is a recent piece by Michael Lewis in Vanity Fair on Whitney’s call. Wow! Really hard to believe. Pretty soon she’ll be arguing the definition of ‘is’. I have no problem with ballsy high profile calls but jeez how about admitting when your wrong? At least Bill Gross, who went short treasuries earlier this year, admitted he was wrong and reversed course. And saying you will be right eventually is just as bad. An old saying on Wall Street is ‘being late is being wrong’ or something like that. I have to agree with Alexandra Lebenthal here , when she says “She was wrong, she is wrong, and she will be wrong,” For a great response to the Vanity Fair piece, see Bond Girl here . OK, enough of that. Lets move on to the muni scare du jour.
The new muni scare is a potential change in the tax exempt status of munis for high income investors. So far this scare is just hype as the muni market has not reacted at all this new scare. As part of the administration’s latest job bill, the proposal is to limit the amount of tax exemption for high income investors in municipal bonds. Now, for today I just want to assume that if any of this passes into law and in that case pretty clear that would be a negative for munis. How much is a subject for another post. We could go into all kinds of scenarios to measure the potential impact, the probability of passing into law, etc… but as it turns out all that is completely unnecessary right now. Sometimes I wonder if anyone bothers to look at fundamentals anymore before stirring up the pot. So, first lets look at my favorite metric for munis, as I did in my last post, the spread (yield difference) between the US 10 yr note (taxable) vs the average 20 yr municipal bond. My updated graph is below.
Can we all spot the obvious? Not only is the spread between the 20yr muni and the 10yr note still at historic levels but 20 yr munis yield more than taxable 30 yr treasury bonds. The obvious fact is that all this tax nonsense only matters when munis yield less than treasuries! Forget anything having to do with taxes and just look at the yields. Lets take the largest long term treasury ETF, TLT, and compare it to the largest muni ETF, MUB. TLT currently yields 3.4% and has a duration of 15 yrs. MUB currently yields 3.43% and has half the duration at 7 yrs. Irrespective of tax considerations MUB is a better investment. In fact, across the entire yield curve, from 2 years on out, municipal bonds are currently yielding MORE than treasuries. See here .
And it gets better. With munis savvy investors can actually go and pick undervalued bonds and pick up some extra yield. So for example you could go out and buy a value muni CEF, like NUV , which uses zero leverage, yields close to 5%, and has a duration of about 9 years. And the bonds it owns were bought about at 80 cents on the dollar. That’s a good investment as well regardless of tax considerations. And to boot you have the bid provided by the fed having committed to keep short terms rates at zero for the next two years and the recently launched operation twist in order to bring down longer term rates.
In summary, the muni market non reaction to this latest scare seems pretty appropriate. Maybe its learned its lesson from last year’s scare. First, with the gridlock in government odds are nothing comes to pass. And even if it does, it doesn’t matter. Currently munis have higher yield than US treasuries across the entire yield curve so the tax consideration don’t matter at this point. I still like munis here, in particular long term munis either through a leveraged or a non-leveraged muni CEF. In fact, I wouldn’t mind seeing a negative market reaction to this new scare so I can load up on some more. When muni yields dip below US treasury yields it will be time to dig into this issue a little deeper.