“Investors,” The Wall Street Journal headline reads, “are hungry for U.S. corporate bonds.”
The economy seems to be growing, albeit slowly, and the premium demanded by investors on corporate debt over government bonds is at its slimmest margin in six years. In other words, the article of Dec. 15, 2013, states, investors are confident they will be repaid.
Fair enough.
So what are the yields investors are “hungry” for? Let’s crunch the numbers.
High-grade corporates are yielding 1.21 percentage points more than Treasuries of a comparable maturity, down from 1.45 a year ago, according to the article. That means investors today should expect to find high-grade corporate bonds yielding about 5.07%, before factoring in federal, state and local taxes.
Junk bonds, whose yields are 3.96 percentage points above Treasuries vs. 5.09 a year ago, are yielding about 7.82% today before taxes.
Not so bad, considering the “low interest rate environment” in which we find ourselves today.
The real deal
Suppose, however, there was another sector of the bond market offering even higher yields with a miniscule default rate over the last 100 years. These bonds allow investors to sleep peacefully at night without having to pore over the latest financial news headlines and enable them to harvest a steady, dependable stream of income.
What’s more, they’re now selling at bargain prices.
As you might have guessed, we’re referring to tax-free municipals, where high-quality issues can be purchased to yield 5.00%.
Think about it: To match that mark, investors in the 39.6% tax bracket would need to find taxable bonds yielding 8.28%. For those paying 28% to Uncle Sam, it would require taxable bonds yielding 6.94%.
In other words, those high-grade corporates yielding 5.07% produce a net return of only 3.06% for investors in the 39.6% federal tax bracket and 3.65% for investors in the 28% tax bracket.
As far as the junk bonds yielding 7.82%, their after-tax yield would be 4.72% and 5.63% for investors in the 39.6% and 28% brackets, respectively.
Add in the surcharge on investable income imposed by the Affordable Care Act, and the gap between munis and corporate bonds becomes even wider.
Not so appetizing after all – and the differences between munis and taxable bonds becomes even more dramatic when adjusted for state and local taxes.
Fears lead to opportunity
In fact, muni bond investors find themselves in a uniquely advantageous position right now.
As we discussed previously (“Avoiding Interest Rate Roulette“), yields turned significantly higher over worries the Fed would end its bond-buying program, the mass liquidation of muni-bond fund shares and anxiety in the market over the Detroit bankruptcy. Add in investors taking year-end losses in this supply and demand driven market, and the result is creation of extraordinary value in the muni market, though we don’t expect this anomaly in the fixed-income markets to persist.
The Fed has promised to keep interest rates low for an extended period of time, replacing fears of inflation with more realistic concerns of deflation. Contrary to many pundits, Detroit’s well- telegraphed predicament did not signal a municipal Armageddon, and amid the wrangling over the city’s finances, bond insurers have promised to step up to protect insured bondholders.
There will be less new borrowing in the muni market than in previous years and the number of refunding issues are decreasing. Meanwhile, most states and municipalities are seeing marked improvement in their fiscal outlook, which should continue as the economy grows.
Today, the smart move for income investors who have retreated to short-term money market instruments is to take advantage of this remarkable opportunity and reenter today’s municipal bond market, particularly as higher taxes loom.