Pity the poor financial writers who cover the bond markets.
For years they have proclaimed a “rising interest rate environment” and sounded the death knell of state and local finances and municipal bonds.
Now that investors are flocking to tax-free bonds, they’ve changed their tune. Munis are “poised for resurgence” and now could be “the best income investment” of the year, according to the pundits.
Why the turnaround?
For one thing, fixed-income investors are starting to see more clearly the implications of last year’s tax-rate hikes. Take a look, for example, at the return on long-term AAA-rated munis yielding 3.75%. In 2012, the taxable-equivalent yield would have been 5.76% for investors in the top federal tax bracket, which at the time was 35%.
In 2013, when the highest tax rate jumped to 43.4%, including the tax from the Affordable Care Act, the taxable-equivalent yield rose to 6.62%. That represents a 15% bump in return and considerably more for investors paying state income taxes. No other bonds of similar quality, taxable or otherwise, come close to matching that return.
Scary headlines went away
Another important factor in the change of attitude is that doomsayers have less to harp on. Despite dire warnings to the contrary, the fiscal plight of Stockton, Detroit and a few other cities did not portend a wave of municipal defaults.
What did happen was that state and local governments began a slow but steady recovery. With an improved economy, state coffers have experienced better-than-expected revenues. In fact, state budget officials are expecting revenues to reach pre-recession levels, according to a New York Times report and, ironically, politicians are now fighting over what to do with budget surpluses.
Investors go long
In the midst of their carping, the soothsayers said short-term bonds were the way to go, as inflation and interest rates were on the verge of a dramatic spike.
Of course, interest rates never shot up, and with the tepid economic recovery, they have actually begun to move lower. Meanwhile, inflation remains anemic, and continues to trend much lower than the Fed’s target rate announced more than two years ago.
So where have investors turned?
The longest-maturity bonds, once in the doldrums, are now the top-performers in local-government debt, Bloomberg reports. Munis due in 22 or more years have earned 3.6% so far this year compared to 2.4% for the entire muni market. Last month, the longest-dated debt had its best performance in two years.
For individual muni investors, it has – and always will – pay to go long. When buying 30-year benchmark munis vs. bonds that mature in two years, investors now reap 3.5 percentage points of extra yield, which exceeds the five-year average spread of 3.3 percentage points.
As we’ve often pointed out, successful municipal bond investors don’t experience whiplash trying to follow the financial seers. Last year, amid the din of doom, they understood that the exodus in bond funds was caused by headline hysteria and created unusual investment opportunities.
They invest when funds are available, fully cognizant of the risk in high-quality issues (negligible) and the income advantages of long-term bonds (considerable).
They continue to follow sound investment principles, maintaining their focus on generating a steady, dependable stream of tax-free income.
They understand that bonds are bought for income, not capital gains, which makes fluctuations in market value – and the wrongheaded prognostications of pundits – irrelevant.