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Stocks & Bonds

Municipal Bonds' Growing Allure

The prospect of higher tax rates is driving investors to exempt offerings.

By Jennifer Woods, Special to CNBC.com

In the wake of the financial meltdown, the tax-free, municipal bond market has been attracting more than the usual high-tax bracket crowd and though 2010 is unlikely to match the stellar returns of 2009, investors still have good reason to look around.

“The municipal bond market is an attractive asset class at this point in time,” says Ronald Schwartz, managing director of StableRiver Capital Management, which manages the Ridgeworth Investment Grade Tax-Exempt Bond Fund.

Combine the likelihood of higher tax rates with strong yields and a favorable supply-and-demand picture and the market's prospects remain bright going into 2010, say analysts. Returns for high-grade municipal bonds ran between 11.5% and 13% in 2009, as the economy shrank and interest rates fell, which is about as good as it gets.

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“Unless there is an unforeseen downturn in the economy, you won’t see returns that high.” says Hugh McGuirk, who heads municipal investments at T. Rowe Price. “Where interest rates are, we can’t keep going down.” Instead, McGuirk expects returns to be closer to the 5-percent average of the past decade.

That may still be enough to attract gun-shy investors looking to pull money out of stocks and other riskier fixed-income assets or new retirees who see munis as a way to supplement lost wage income, replacing stock dividends that were cut sharply or eliminated altogether by cash-strapped companies.

Traditional investors, of course, are already looking at higher taxes in 2010 and the prospect of yet more tax hikes in 2011, and the lure remains. Returns on muni bonds are free from federal income taxes (and in many cases state taxes as well) and the bonds carry better credit ratings than corporate bonds.

“We know taxes will have to go higher,” says Schwartz. “It’s just a matter of how high they are going to go.“

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“We have seen demand pick up with the expectation of tax rates going higher,” adds Matt Zucker, senior vice president of FMSbonds, who adds that for investors who lock in a great rate of return today will benefit as the yields produced become more attractive.

The top income tax bracket, for instance, is widely expected to rise to as much as 40 percent as soon as 2011, having been 37 percent for about a decade.

Zucker also says a favorable supply-and-demand dynamic will also help the market.

Annual new issuance supply through the end of the third quarter totaled $335 billion, down from $389 billion in 2008, according to The Bond Buyer. At the same time, the amount of taxable municipal issues increased this year to $65 billion from $24 billion a year ago.

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About $48 billion has been Build America Bonds, a federal program that allows state and local governments to issue taxable bonds for capital projects and to receive a new direct federal subsidy payment from the Treasury Department for a portion of their borrowing costs.

”That has reduced the amount of new issuances in our market,” says Schwartz. “So we have higher demand and less new bonds coming to market.”

Schwartz also sees something of an internal market shift in the year ahead. “Lesser quality bonds performed very strong this year, having rebounded from last year’s credit crash, but looking into next year we think there is going to be concerns on municipal credit,” says Schwartz. “We are going with quality into next year as we think that is going to hold their value better than some less quality paper.”

Schwartz also likes longer duration muni bonds and recommends investors diversify their investment throughout the yield curve. He cites general obligation bonds, which are secured by a government pledge to use resources such as tax revenues to repay investors, and essential service revenue bonds as good examples.

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Zucker likes Duval County Florida School Bonds, which offer a 5.25 percent coupon with a July 1, 2035 maturity date and trade at par; and Lehigh Northampton Airport Bonds, which have a 6.00 percent coupon are due May 15th, 2030 and can be bought at par.

“Even though there may be some degradation of credit quality around the edges we are still a good quality market,” says McGuirk.