Among all of the craziness going on in the financial markets, here's something else to chew on: the yields on municipal bonds continue to beat the pants off of U.S. Treasury yields. And it's been that way for most of this year, a duration that's highly unusual.

Historically, the 30-year municipal bond yield to 30-year Treasury bond yield ratio has averaged nearly 90%. Right now it's 125%, and muni yields are beating Treasury yields across the maturity spectrum by ratios above 100%. To put that into perspective, the munis-to-Treasury ratio has topped 100% only a few times since the mid-80s. 

"Generally, when we see ratios above 100% these situations don't last long," says John Pomeroy, portfolio manager for Franklin Templeton Investments' municipal bond department. "But in this cycle we've seen it for an extended period of time because things are going on in the muni market that have never happened before."

And that's creating some really fat dividend yields for bond investors. "We see tremendous opportunity with munis at 120% to 130% to government where you're getting pure nominal (muni) yields to Treasury yields before any tax benefit," Pomeroy says. "We're looking at after-tax yields in the 8% to 10% range, depending on what part of the credit spectrum you're buying."

The surge in muni yields began earlier this year with the troubles at two municipal bond insurers--Ambac and MBIA--that caused a lot of people to sell their munis. It continued with the various headline events that have rattled the financial markets (Bear Stearns, Lehman Brothers, etc.) and the forced selling by hedge funds and other investors who dumped their munis to raise cash at a time when troubled financial institutions weren't buying much of the paper being thrown into the market. That created a flood of muni bonds that no one wanted. Muni prices plunged, and yields rose accordingly.

At the same time, the flight to quality into Treasuries caused higher prices and lower yields in those securities. 

Of course, the big question is how long will this last. "Right now we're in a period of fragile stability," said Mark McCray, managing director at Pimco, during a recent interview on Morningstar's website. "It appears for the moment the worst seems behind the muni market."

McCray said he was very cautious about the upcoming credit cycle because many municipalities are facing budget crunches in the tough economy. They'll have to raise taxes and/or cut spending. He expects some downgrades, but doesn't foresee a "violent" credit cycle.

The plight of Jefferson County, Alabama (Birmingham is the county seat), where the sewer authority's aggressive use of exotic derivatives blew up this year and left it on the brink of defaulting on its nearly $3.2 billion outstanding debt and going bankrupt, is a cautionary tale that muni bonds aren't always as safe as being in your mother's arms. But Pomeroy says muni default rates are historically very low. "Less than 1% of munis rated AAA to BBB have defaulted," he says.

Pomeroy says muni bond investors need to consider three things. One, investors (and their advisors) need to know the credit risks of the bonds they're buying to avoid getting stuck with potential bombs. Second, they need to be aware of their potential exposure to the alternative-minimum tax, which can weigh into tax-equivalent yields. Finally, he says investors buying muni bond mutual funds must look under the hood to see how much leverage the funds employ. "During the past 10 years we've seen a lot of open-end funds using more leverage in their strategies," he says. 

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