By
iShares ETFs
:
Faced with a
looming fiscal cliff
and low Treasury yields, investors are showing a renewed interest
in municipal bonds. In the past month and half, we've seen
investors take a particular interest in muni
ETFs
including the iShares S&P National AMT-Free Municipal Bond Fund
(
MUB
) and the iShares S&P Short Term National AMT-Free Municipal
Bond Fund (
SUB
).
Why? Right now, munis are attracting interest from investors for
a number of reasons.
First off, investors who are searching for income are turning to
muni bonds because they offer a more attractive yield than
Treasuries. Historically, munis have yielded less than US
Treasuries as their income is exempt from federal taxes. The ratio
of AAA municipal bond to US Treasury yields has averaged about 93%
over the past 10 years, according to Bloomberg. But in times of
concerns over muni credit quality this ratio has increased to over
100%. Although a few city and local municipalities having declared
bankruptcy this year, today the overall health of municipal issuers
is relatively strong. Despite this, muni yields are still over 100%
of the yields on US Treasuries - on a historical basis, investors
are being paid a relatively attractive rate to take on muni credit
risk.
Another benefit of munis is their current tax-exempt status.
With the impending fiscal cliff, some investors are concerned that
tax rates might rise. In such an environment the tax-exempt income
provided by muni bonds would be even more beneficial relative to
taxable investments. It appears that right now investors are
weighing this benefit against conversations that have been taking
place in Washington around potentially removing municipal bonds'
tax-exempt status. While changing the tax policy that applies to
munis has been discussed in the past, each time it has induced
major pushback from municipal investors and issuers. For instance,
this topic came up last year (and I wrote
a blog
about it) when President Obama unveiled a $450 billion job creation
plan that included a proposal to cap the tax breaks for certain
municipal-bond holders.
It appears that right now investors believe munis will maintain
their tax-exempt status. In fact, if higher taxes are imposed in
2013, then munis could look more attractive. Unless Congress acts,
the top marginal rate will increase by 4.6% and the Affordable
Healthcare Act will add 3.8% to investment income. So a 4% muni
yield would compare to a 7.1% yield on a taxable investment
assuming a new marginal tax rate of 43.4%. Investors have taken
notice of these attractive valuations and have added $48.1 billion
into muni mutual funds and ETFs this year.
(click to enlarge)
Supply and demand technicals are also making municipal bonds
attractive going forward. While investors have been demanding more
munis, as evidenced by the above chart, municipalities are issuing
less debt. The BlackRock Investment Institute estimates a decline
of the amount outstanding in the muni bond market by $25 billion
annually in the next 3 years. With fewer new infrastructure
projects and a decrease in local spending, there is less need for
municipalities to issue more bonds. Such a scenario would result in
less supply, which would pressure prices higher and yields
lower.
What does it all mean? Given today's attractive valuations, tax
benefits, and the outlook for supply and demand, we currently favor
munis relative to other sectors of the bond market. While the
fiscal cliff is a cause of uncertainty, there may be a silver
lining in municipal bonds.
Source: Bloomberg, BlackRock and the Investment Company
Institute
Disclaimer:
Bonds and bond funds will decrease in value as interest rates rise.
A portion of a municipal bond fund's income may be subject to
federal or state income taxes or the alternative minimum tax.
Capital gains, if any, are subject to capital gains tax.
Original post
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