Careful Investors Can Find Great Deals in Munis

As this week dawned, I could almost hear a collective sigh of relief. We may have come to the brink, but we didn’t fall over it. At least not yet. Thank goodness for weekends. I’d never thought of them this way until the recent market panic, but they function much like the “circuit-breakers,” the trading halts imposed after the 1987 crash, a much needed cooling off period in times of stress.

As liquidity begins to trickle again through the global economy, and after an active two weeks in the stock market, I’m taking a break. My next buying target is 1475, and with the Nasdaq at 1770 (based on Monday’s close), I’ll go out on a limb and suggest my stock buying is over for at least a week. That’s given me the time to take a look at a part of the market I’d abandoned years ago: municipal bonds.

My attention was captured last week when I heard the unmistakable voice of former New York City mayor Ed Koch on the radio pitching New York City municipal bonds, triple-tax-free for New York City residents like myself. Evidently, even a legendary pitchman like Mayor Koch couldn’t overcome the prevailing risk aversion, for I subsequently heard the offering had to be postponed due to market conditions. Still, the offered yield was a remarkable 5.75%. That’s the equivalent to an over 10% return for New York City residents in the top bracket.

If so much other news wasn’t pushing it out of the headlines, the crisis in the municipal bond market would be making the front pages. As investors have fled nearly every packaged or derivative product, there has been turmoil in the tax-exempt market. There were fears earlier this month that California might need a federal bailout because it couldn’t market its bonds; they proved unfounded when California’s issue was actually oversubscribed. Still, the very thought that a state like California might be in trouble spooked many investors. And there seems little doubt that state and municipal budgets will come under pressure given the current economic upheavals and the likely fall-off in revenues.

Despite these fears, the current upheaval has largely been a liquidity crisis, not a credit quality crisis. There have been no recent defaults, but municipal bonds, just like mortgages, have been packaged into all kinds of products much like the now dreaded collateralized debt obligations and mortgage-backed securities. The crisis in tax-exempt auction rate preferreds, which I’ve written about, was just the tip of the iceberg. The upshot is that yields in the tax-exempt markets have soared well above rates for Treasurys of similar duration. While not unheard of, this is very rare, since municipal bond yields are tax exempt and, as a result, almost always yield less than comparable Treasurys or taxable bonds. According to PIMCO, this almost always represents a buying opportunity since those spreads should revert to a more normal level.

So last week I ventured into the market for municipal bonds for the first time in years, a task that proved more daunting than I remember from my last purchases. Though municipal bonds are typically available through any full service or discount broker, I’m told that many firms have slashed their inventory during the recent liquidity crisis, not only contributing to the turmoil but leaving them with little to sell. The recent volatility in the market also seems to have driven up spreads between the bid and asked prices to unusual levels. Despite these hazards, I was able to get a New York City general obligation bond yielding 5.5%. Municipalbonds.com offers a comprehensive list of available bonds by state, with recent bid and ask prices and corresponding yields. I glanced at the offerings in California, Illinois and Massachusetts, all of which had outstanding bonds with yields in the 5% to 6% range, and a few even higher. Since nearly every bond is different, it’s important to read the fine print. My advice is to beware of anything offering yields that seem too good to be true (at least one bond was reported to be yielding over 50%).

Buying an individual bond is a way to take advantage of the recent turmoil. In some cases investors can buy newly issued bonds directly from their state or municipality. Another possibility is to buy one of the many tax-free municipal bond funds, some of them tailored for specific states and cities. Most have had terrible years, given the credit crisis, but Pimco’s High Yield Municipal Bond fund currently yields 5.83%. These funds offer immediate diversification and professional management. However, because their holdings are replenished constantly, they don’t have fixed maturities and aren’t likely to benefit as much from the recent dislocations in the market. With an individual bond, you can always hold it to maturity.

Like all investments, buying a municipal bond is a vote of confidence in the future. As former mayor Koch reminded me, it’s also a way of contributing to your communities. Especially in these difficult markets, our public institutions need you.