Improving yields could ease investor fear of rising interest rates.

    Despite being a veteran of the municipal bond business, Geoff Schechter is having a hard time convincing his mother about the merits of tax-free interest income. "She's just not all that interested in a tax-free yield of 3.5% on a ten-year AAA muni," laments the manager of the MFS Municipal Bond Fund.
    Schechter's mother isn't the only one taking a cautious view of municipal bonds. Despite the threat of rising interest rates, demand for Treasury securities from institutions such as pension funds, insurance companies and foreign investors has provided ample pricing support for that market. But municipal bonds, whose major audience is U.S. retail investors, are proving to be a tougher sell.
    "A lot of people just aren't comfortable with the idea of buying a ten-year municipal bond that's only yielding 3.5%," says Mary Beth Syal, manager of Payden & Rygel's Tax-Exempt Bond Fund. "It's a case of sticker shock."
    At the same time, bonds used to pay off outstanding higher-rate debt have added plenty of supply, with refunding bond issuance during the first five months of the year up 42% over the same period last year. And while some indicators pointing to moderating growth in the economy have kept bond prices buoyant and brought longer-maturity yields down, the pattern has been more pronounced for Treasury securities than municipals.
    The environment has narrowed the yield gap between taxable Treasury bonds and high-quality municipals, which translates into higher after-tax returns for investors. According to Syal, municipals "are relatively inexpensive compared to other fixed-income asset classes. And they are likely to hold up better than taxable bonds if rates rise because they don't respond as much to changing interest rates."
    In 2004, ten-year triple A municipal bond yields stood at an average of 86.5% of the yield available from ten-year Treasury securities. At mid-year 2005 the ratio was over 91%, according to Municipal Market Advisors of Concord, Mass., a bond research and consulting firm. For someone paying federal taxes at a rate of 35%, the 3.55% consensus yield on a ten-year triple A municipal bond would produce a taxable equivalent yield of 5.46% at a time when ten-year Treasury securities yielded 3.9%.
    The longer end of the yield curve has seen even more dramatic yield compression and higher municipal-to-Treasury yield ratios. In a recent video commentary Michael Pietronico, managing director at Evergreen Investments, says, "We're seeing high-quality municipal bonds in the 12- to 15-year maturity range with yields between 92% and 94% of comparable U.S. Treasury bonds. Historically, the ratio has been in the range of 85% to 88%." He labeled 12- to 15-year maturities the "sweet spot" on the yield curve for municipals.
    Beckoning those willing to move into the longest maturities are triple-digit ratios on 30-year bonds, an indication that tax-free municipal yields equal or surpass the yield on taxable Treasury securities. The ratio at the long end hasn't been this high since June 2003, and over the last ten years it has averaged about 91%.
    Schechter thinks the current environment offers good swapping opportunities. "If someone has a ten-year Treasury coming due, it can make sense to lock in the boost in value and swap into a municipal bond," he says. "The municipal would not be impacted as severely in a rising rate environment. And there is also some chance for price appreciation from ratios reverting to their historic norm." Schechter says it can even make sense to defy conventional wisdom by putting a longer-term municipal bond into a tax-deferred account, if its yield equals or exceeds that of comparable Treasury securities.
    Although it might be a stretch to label any bond a safe haven when interest rates rise, municipal bonds have been about two-thirds as volatile as government bonds over the last ten years, according to the Schwab Center for Investment Research. So if rates rise, municipal bond prices are likely to drop less. That happened in 1994 and 1999, when munis outperformed Treasuries by 3.1% and 7.2%, respectively.
    Additional pricing support for the municipal market could kick in if the alternative minimum tax is repealed, since the interest from some private-activity municipal bonds is subject to the tax. On May 23, Senator Charles Grassley, chairman of the Senate Finance Committee, introduced a bill to repeal the dreaded AMT.
    Syal says that while the AMT is "clearly an issue that needs to be addressed," fewer bonds with interest subject to the alternative minimum tax have been issued in recent years. In 2003 and 2004, about 6.5% of total new issuance was subject to the tax, compared with an average of 9.6% over the last 15 years, she notes.
    Both Syal and Schechter feel that with spreads between investment-grade bonds and high-yield bonds fairly tight, this is not a good time to sacrifice quality for a higher yield.
    "Two years ago, the spread between a triple B bond and a triple A bond was around 130 to 150 basis points," says Schechter. "Now, its only about 75 to 80 basis points. Quality spreads haven't been this tight since 1998." Tighter supply caused by strong inflows into high-yield municipal bond funds and a slowdown in issuance at the lower-quality end of the market have contributed to the compression, he says.
    While an economic slowdown could affect state and local tax revenues, Schechter thinks that investors who take a belt-with-suspenders approach can be fairly confident that an issuer will deliver principal and interest as promised. "A large portion of the municipal market is insured," he says. "And studies show a very low default rate among investment-grade issuers."