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The Case Against Municipals, the Case For Treasuries

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...municipals will lag Treasuries in a rally.

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I get lots of e-mails and instant messages daily asking what I think of this or that, usually as it relates to the bond market or asset allocation. Yesterday, an old friend of mine from college sent me an e-mail asking "I agree with your bond theory and so do the boys at Pimco. Do you think the total AFTER TAX return for Treasuries will exceed that of municipals?" I have stated recently that my firm has shunned municipals and corporate bonds in favor of Treasuries and Agency bonds. The answer to my friend's question was too long so I gave him a call to both catch up on old times and answer the question. Below I will share with you my reasoning for avoiding municipals now.

Municipal bonds usually trade relative to Treasury yields. More specifically, municipal yields are usually quoted in the institutional marketplace 'as a percentage of Treasuries.' Depending on the fundamentals of an underlying bond, or its structure (call features, sinking fund, credit rating, etc), bonds trade in a wide range relative to Treasuries. Historically, long-term munis have traded in a range of 87% of Treasuries. In other words, on average, say a long term-Treasury is 5%, the 'normalized' yield of a muni should be 4.35%. Generally speaking, if bonds trade above 87% (in terms of yield) of Treasuries, they are considered relatively cheap. In contrast, if they trade BELOW 87%, they are considered expensive. Shorter term municipals usually trade 'tighter' or around 75% of Treasuries. Readers of my commentary know that my firm has been an active seller of short-term municipals lately as we are selling them in the 68%-70% of Treasury yield range. Even with a 35% tax rate, you can see how there is no real value here on a 'tax equivalent basis' and is why my firm favors Agency bonds with yields in the 6% range. Long term munis around 4% offer no value to us, so we are avoiding them as well. Note that last fall, the opposite dynamic existed when, believe it or not, we were buying high quality municipals with yields 100-105% of Treasuries. It was a relative value call, not so much a call on the direction of rates. Eventually, the spread tightened and we sold at tidy profits.

In my explanation to my friend, I threw in one other reason to avoid long term munis. Let's say you have an account at a large brokerage firm and you have some cash to deploy. So you ask your broker to find some long-term municipals for you. He calls his trading desk or scans their inventory and says 'I can sell you 100,000 of high-quality bond X at a 4% yield for a 30 year period.' Most of us have been conditioned to yields much higher than this over the last 25 years, and the answer most of the time is 'no thanks.' It occurs to me that this is the most important dynamic in the Treasury/Municipal relationship these days. While the tax equivalent yield in the 35% tax bracket of a 4% tax free bond is 6.15% (4% divided by 0.65%), it actually is a higher after tax yield. But here is the catch. There is a sticker shock below 4% long term yields in my experience and it's why I was able to buy municipals relatively cheaply last year. So, while my firm expects a slower economy and lower long-term yields down the road, we favor Treasuries as from a PERFORMANCE PERSPECTIVE, I think municipals will lag Treasuries in a rally. I just don't think investors will embrace a sub 4% rate, even in a rally. If we are correct and Treasuries rally, we would likely shed Treasuries at that time in favor of municipals. When markets fall, and yields rise, municipals usually outperform.

I thought this dynamic is interesting and wanted to share it with you. Incidentally, I see the same dynamic in corporate bonds as well and am avoiding them entirely. I ask the rhetorical question - Why would one buy a bond issued by a bank like Citigroup at a yield spread below a bond issued by GNMA, which has 'full faith and credit' backing of the U.S. Government? The answer of course is, you wouldn't.
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Position in Treasuries and Agency Bonds

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