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Tax exempt bonds

Chris Farrell Oct 15, 2008

Question: Can you explain why an ETF that invests in 100% government insured revenue and general obligation municipal bonds would be sliding so precipitously on good days and bad ones? Thank you. Marysa. Delray Beach, FL

Answer: The tax exempt market still has a stodgy image of a market that barely moves with wealthy investors complacently clipping their coupons. The market hasn’t been that way for a long time and lately it has been on a wild ride. The slide in value in your exchange traded fund or ETF reflects investor nervousness over credit quality, state and local government finances and the recession.

First, a brief definition: Tax exempt or municipal bonds are sold by state and local governments to fund roads, sewers, schools, stadiums and the like. General obligation bonds (GOs) are backed by the full taxing power of the state. It’s the safest sector of the tax exempt market. Revenue bonds are typically backed by a stream of income, say, from a toll road. The income backing a revenue bond can be fairly assured or very risky.

In recent decades, state and local governments boosted the rating–and lowered the yield–mostly of their revenue bonds by buying private insurance that protected investors in case of default. It was a great business for the private insurance companies since default rates in the muni market have been traditionally low in recent decades. (I always thought the business was a scam but that’s a story for another day.) In recent years, the insurance companies decided to make even more money by getting into riskier businesses where they could charge higher fees–including exposing their balance sheets to subprime loans. The move backfired badly with the housing market implosion and the credit crunch. The insurance company debacle has roiled the market.

What’s more, state and local government revenues are crimped by the downturn in the economy. The consensus is that the tax revenue situation will only get worse since we are either in a recession that is spiraling downward fast (as I think) or the country is about to enter a recession that could get severe (the opinion of many economists). The expectation is that the tax exempt market default rates will be higher than recent experience, too. The last time the there were a lot of state and local government defaults was during the Great Depression.

Taken altogether, the uncertainty has driven bond prices down and bond yields up. The nervousness in the market is so great that muni bond yields are now higher than comparable U.S. Treasuries. That’s amazing considering that muni bond yields are exempt from federal taxes. (Many muni bonds sold within a state are also exempt from state and local taxes. But since many muni bond mutual funds and ETFs buy bonds issued across the country you’ll pay state income taxes on that kind of investment.)

Let’s assume you’re in the 35% federal income tax bracket. You also pay a 10% state and local tax rate (the national average). Today, the 3-year Treasury note yields about 3%. The highest quality muni bond with a comparable maturity yields some 3.6%. The muni bond yield is the equivalent of a 5.5% taxable yield. If you’re in the 28% tax bracket the muni bond is still paying the equivalent of a 5.1% taxable yield.

Munis are offering their investors attractive yields, but the higher yield reflects greater risk.

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