A different take on the unattractiveness of municipal bonds has nothing to do with the distressed condition of state budgets or with the possibility that their tax-exempt status may be endangered by fiscal cliff discussions.
This view, held by the Litman Gregory research team, says that municipals are unattractive because their yields do not reward investors enough.
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Municipals face the same challenges and problems that plague their taxable counterparts. And in a fear-driven market, they would likely mirror a rally in Treasuries as safe haven investments.
At the same time, tax-equivalent yields are so low it is unlikely that municipals will match the returns of taxable bonds.
Annualized returns are projected to range between 3% and 6% over the next five years, depending on the state of the economy.
For municipals to match those returns, long-term Treasury bond yields would have to drop from approximately 1.6% to approximately 1%.
Supply and demand forces may also be different than investors think. Since the market collapse in late 2008, demand for municipals has pushed the market up 25%.
This means that most of the demand in anticipation of higher taxes is likely already factored into the market.
An income tax increase from 35% to 39.6% for top wage earners isn’t likely to increase demand for tax-exempt bonds.
Some of the recent demand may have come from investors crossing over into munis as yields in certain parts of the taxable fixed-income markets have been less attractive than munis even on a pre-tax basis.
New municipal issuance has also been low. This has also contributed to the rise in muni prices and the historically low yields.
The fiscal problems of states and cities are evaporating as municipalities improve their fundamentals.
The advice is not to abandon municipal investments altogether but to perhaps take care not to overinvest
in an effort to offset rising tax rates.