Municipal bonds are looking better and better

(MoneyWatch) Historically, AAA-rated municipal bond yields have traded at a discount to Treasuries. However, the recent financial crisis has changed that, and you may want to give munis another look for your portfolio.

Over the long-term, AAA-rated intermediate-term municipal bond yields have typically traded at between roughly 75-85 percent of the yields on similar maturity Treasuries and have rarely been above 100 percent. This is due largely to the federal tax exemption they enjoy.

• Why not short Treasury bonds?
• Who are the most (least) accurate stock gurus?
• Can credit ratings on muni bonds be trusted?

However, the financial crisis that began in late 2007 caused a flight to the higher quality and greater liquidity provided by Treasury bonds. In turn, this led municipal bond yields to be generally higher than Treasury yields. The peak of the flight to safety came in early 2010, with municipals yielding as much as 160 percent of Treasuries.

Even as the crisis subsided, municipal bond yields continued to trade at a premium, somewhat due to dire predictions about the market likethe one made by Meredith Whitney, which "spooked" many investors and led to a massive exodus by retail investors from municipal bond funds.

As of Monday, Bloomberg showed that five-year Treasuries were yielding 0.80 percent and five-year AAA-rated municipals were yielding 0.91 percent. Despite the federal tax exemption, municipals were yielding 114 percent of Treasuries. For 10-year bonds the figures were 1.95 percent for Treasuries and 2.04 percent for munis (105 percent of Treasuries).

The question is why do municipals continue to trade so cheap relative to Treasuries? My colleague and co-author Jared Kizer proposes four explanations.

• Broker-dealers have contracted their balance sheets, holding less municipal bond inventory. That has made the market a bit less liquid, which would push municipal yields up relative to Treasury yields.
• The bond buying programs of the Federal Reserve suppress Treasury yields but not municipal yields.
• Muni investors have incorporated the risk that there might be changes in the tax exempt status of municipal bonds. That risk creates the demand for a larger risk premium (higher yields).
• Even with talk of the worthiness of the U.S. government's credit rating, Treasuries are still the go-to "safe haven" option, reducing their yields relative to other alternatives.

All this has been actually been good news for municipal bond investors, who have reaped higher yields than would have been the case otherwise. And the further good news is that credit risks on the highest quality bonds have actually improved dramatically as state and local governments have taken actions to address their deficits. Budget gaps have been closed by layoffs of public employees, greatly reduced services and increased taxes and fees.

In summary, the atypical, higher than Treasury yields have made municipal bonds attractive alternatives for taxable investors, even those not necessarily in the highest tax brackets. So, if you have avoided municipal bonds because you thought your lower tax bracket status made them unattractive, it's time to take another look and do the math. And if you've been scared off by dire forecasts of municipal defaults, it's also time to reconsider.

To make sure you minimize credit risks, I recommend that you follow the same buying parameters my firm uses: Limit your holdings to only general obligation or essential service revenue AAA/AA-rated bonds. Bonds that fall within those parameters have historically experienced losses that are very close to zero. That held true throughout the recent financial crisis and it even held true in the Great Depression.

Image courtesy of Flickr user 401(K) 2013.