Why I Stand By Muni Bonds

I’m astonished when I hear dour financial advisers question the soundness of tax-exempt municipal bonds. In my mind, munis are a uniquely American success story that reward millions of savers, the middle class as well as the rich. The skeptical attitude toward munis erupted with California’s budget crisis eight years ago, and Detroit’s fiscal woes reinforced the view. Serious trouble is currently confined to Puerto Rico, but the negativity persists, feeding on the low opinion people have of government services and public employees. Yet for years, muni bonds have provided high returns with low risk, and they continue to do so.

The muni-interest advantage is compelling. Yields on high-quality muni bonds are normally about 85% of those of Treasuries of equal maturity; sometimes, muni yields exceed Treasury yields. In either case, munis offer bonus yield when you take their tax benefits into account. In early April, a 10-year Treasury yielded 1.8%, and the Merrill Lynch 7–12 Year Muni index yielded 1.6%. For someone in the 28% federal income tax bracket, a 1.6% tax-exempt yield is equivalent to 2.2% from a taxable bond. And for someone in the highest, 43.4% bracket, the taxable-equivalent yield of a tax-free 1.6% is 2.8%.

But tax savings are not the only lure of munis. Treasury-bond rallies (and the accompanying drop in yields) tend to coincide with bad economic vibes or global turmoil, which sends rivers of money seeking safe haven into U.S. government bonds. The performance of munis, by contrast, reflects U.S. prosperity. A vigorous recovery in jobs, tax revenues and real estate values—not Congress or the Federal Reserve—revived California’s bonds. Today, thanks to assorted local and regional booms, bonds with interest payments that flow from ordinary economic activity are flourishing.

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Standard & Poor’s breaks down the $3.7 trillion tax-exempt bond market not only by maturity and ratings tiers but also by function. In recent years, one of the best segments of the muni market has been toll-road bonds, which returned 2.1% in the first quarter of 2016, 5.0% over the past year and 5.4% annualized over the past three years (all returns are through March 31). Hospital, school construction, and airport and other transportation-related bonds, all backed by dedicated tax revenues and fees, are also performing splendidly. State general-obligation (GO) bonds, with a 1.2% return for the first quarter and 3.2% for one year, have been the laggards, hurt by weak links, such as Illinois. But not one single-state municipal fund has lost money so far this year.

Best bets. I’ve long preferred essential-service revenue bonds (such as those from toll roads and water and sewer systems) over GOs because even in an iffy economy, people shower, and trucks and cars travel long distances on highways. Many pros agree. Last December, John Loffredo, head of the muni team at MacKay Municipal Managers, part of New York Life, offered a list of predictions for 2016. Coincidentally, one forecast was that revenue bonds would outpace GO bonds. Another was that transportation bonds would be the best single sector. So far, he’s two for two. Loffredo also prophesied that high demand and a moderate amount of new supply would continue to bolster tax-exempt prices, a theme that has been at work for several years. That’s also proving accurate. Supply is up in 2016, but demand has risen commensurately, much of it from insurers and pension funds.

I called Loffredo to offer him the chance to amend any of his predictions or tone down his enthusiasm if he thought these early-year gains might be stealing extra returns from the rest of 2016. He said no, he wouldn’t change his bullish views. I completely concur.