Muni bonds: More bang for the buck

With retail investors exiting municipal bonds for the past six months because of sharply rising interest rates and much-publicized default fears, the asset class now represents an island of high-quality value in a sea of relatively expensive fixed-income options. Last fall's sell-off in the muni bond market stemmed from the coincidence of three factors: increases in rates from an extraordinarily low level; concerns that the ending of the Build America Bonds program would result in an oversupply of traditional muni bond issues, further driving up rates; and highly publicized fears that a remarkable number of tax-exempt issuers were in dire financial straits. The market correction was significant, with muni bond rates rising by 1 percentage point and their prices falling about 10%. However, with rates now higher — long-term AA debt yields more than 5% — the valuation proposition for investors is more attractive. Paradoxically, fears of a glut of supply haven't been justified. Indeed, the BAB program seemed to have fast-forwarded some of this year's new supply into 2010. This year's new issues are running 50% lower than last year's. And headlines about impending doom among state and local government issuers have proved overblown. Historically, the $2.9 trillion market, with more than 40,000 issuers, has enjoyed a negligible default rate. This spring has been no different, with defaults in the first quarter totaling less than half those in the first quarter of 2010, as tabulated by Standard & Poor's. Although government entities still need to restructure their long-term pension obligations, there are signs of progress. Last month, Maryland reduced its pension burden with a new formula for workers and teachers. Nationally, tax receipts are up. States are starting to take action, with Illinois, for example, raising its personal income tax rate by 66%. At the same time, investors may not fully appreciate that two-thirds of muni bond issues aren't government general-obligation bonds but revenue bonds. These issues are backed by streams of income from water and sewer systems, hospitals, toll roads and even corporations' development and pollution control projects. In combination with the shift in the muni bond market in 2007 from about half insured bonds to about 10% insured bonds, the diverse opportunities in revenue bonds mean that thorough credit research is ever more essential to muni bond investing. Each issue should be examined and rated on its fundamental merits. In this respect, corporate tax-exempt bonds offer a particular opportunity that requires corporate-credit-type research, and that may not be well-known. These industrial development revenue bonds or pollution control revenue bonds are backed by corporations and issued through local, quasi-government entities, such as PCR bonds issued by Potomac Electric Power Co. through the Maryland Economic Development Corp. This year, more than 20% of the T. Rowe Price Group Inc.'s Tax-Free High Yield Fund has been in such IDR and PCR bonds. Investing in corporate tax-exempt bonds is attractive. They provide tax-exempt investors with diversification to a different asset class than general-obligation government-issued bonds; a high level of credit quality, given that corporate balance sheets generally are strong; and an asset class in which deep credit research can add value. Yields have been attractive, too. In January, some tax-exempt bonds issued by corporations were offering higher absolute yields than taxable counterparts issued by the same corporations, a dislocation that drew interest from hedge funds that typically don't invest in municipals. Although that anomaly has dampened somewhat, many corporate tax-exempts are yielding almost as much as comparable corporate taxable bonds, providing, in the 35% tax bracket, taxable equivalent yields of more than 8%. It is time for long-term investors to take another look at the market's relatively high tax-free yields from a high-quality asset class. James Murphy is a vice president of T. Rowe Price Group Inc. and the portfolio manager of its Tax-Free High Yield Fund.