The municipal bond market is likely to be an attractive asset class to investors in the years ahead and the success of California's mammoth sale of securities this week indicates that investors recognize the current appeal of munis.
California sold $6.54 billion of securities in various maturities, the second largest-ever sale of municipal securities behind a $7.9 billion sale by California in May 2004. The sale was "upsized," which is to say that it was increased because of strong demand, with the offering increased from an expected offering size of $4 billion.
An unusual characteristic of California's offering is that it was a "national" issue as much as it was a local issue. In other words, it appealed to investors throughout the nation because of its attractive yields. California recognized as much, running advertisements throughout the country.
Big Taxable Equivalent Yields
The appeal of California's offering is apparent in the yields on the various maturities it sold. California's 2013 maturity, for example, priced at 3.20%, well above 4-year Treasuries, which are yielding about 1.80%. The yield is even sweeter when is adjusted to a taxable equivalent yield, which is the yield that an investor would have to receive in a taxable security in order to achieve the same yield for munis. In this case, the 3.20% has a taxable equivalent yield of 4.93%, for those in the 35% tax bracket.
California's 10-year maturity yielded 4.9%, a whopping 2.1 percentage points more than 10-year Treasuries and a taxable equivalent yield of 7.539%. California's 30-year was sold at a yield of 6.1%, well above the 3.7% yield for 30-year Treasuries and a sweet 9.385% taxable equivalent yield.
The fact that municipal bond yields are higher than Treasury yields is unusual. Historically, munis have tended to yield about 85% of Treasuries, depending upon maturity range, the locality, and the credit rating of the muni. California's 10-year maturity is 175% of the 10-year Treasury, another way of saying that munis are very appealing at the moment.
Who Buys Munis?
To whom do munis appeal? Individuals are the single largest direct holder of the roughly $2.7 trillion in munis outstanding, holding $960 billion at the end of 2008, up $48 billion from the prior quarter. Individuals have additional exposure through mutual funds and money market mutual funds, which held $495 billion and $389 billion, respectively, at the end of the fourth quarter. Insurance companies represent the second largest group of holders, at $369 billion. Commercial banks held $216 billion.
Munis Ascending as an Asset Class
Municipal bonds have gained appeal in recent months although not enough to bring yields anywhere close to their historic norms relative to Treasuries. Several factors are likely to lead to increased ownership rates for municipal bonds both in the short-term and in the years ahead:
1) As I've shown, yields in the present time are attractive from an historical perspective. In the case of California bonds, yields are also in the vicinity of the historical return achieved by investing in the stock market.
2) Tax rates are rising and are likely to stay up for a time because of budgetary challenges at every level of government.
3) The bursting of the financial bubble in 2000 and the financial crisis of 2007-2009 has shattered the appeal of equities to large numbers of investors, who will be seeking safer investments such as bonds. Investors want to be higher on the capital structure.
4) The U.S. population is aging and investors tend to shift more of their money toward bonds as they age.
5) The U.S. savings rate is rising, which will mean more money for fixed-income securities.
We've established the idea the investors are likely to move increasingly toward municipal bonds. Investors that do so must be selective in the current environment, which favors general obligation bonds over revenue bonds, although certain essential-purpose bonds such as those backed by water and sewer revenues are in most cases relatively safe. General obligation bonds are safer because municipalities that issue these securities can raise taxes and fees to cover their obligations. Less safe are bonds based on revenues that can be volatile or subject to impairment because of conditions in the economy or in a specific industry. A standout in this regard is in the market for hospital bonds, where the ability to repay debt has been eroded by losses that hospitals have had to incur because of factors related to the economic contraction. Credit analysis is therefore crucial in the current environment.
In deference to full disclosure, note that I am Chairman of Miller Tabak Asset Management, a firm that manages close to $150 million of municipal bonds.
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