The relative attractiveness of Municipal bonds continues to astound me. With Treasury yields dropping precipitously, tax-free municipal yields seem the hands-down winner of the yield game. Much of this is due to large foreign players elbowing their way into the US Treasury market to hide from worldwide financial turmoil. They have bid prices up accordingly on the bond market’s most liquid vehicles- Treasuries. These buyers would not benefit from the tax-free nature of muni yields, and the muni market is far too fragmented and illiquid for the trillions of dollars that are rolling around looking for a home. But this creates interest rate nirvana for retail investors looking for a nominal return with nominal risks. While the muni market is considered liquid, it is very much an “art trader’s market”. The muni market is filled with $50,000 and $100,000 pieces for sale, so bidding in $100 Million chunks is completely out of the question. Accordingly, institutional buyers are mostly absent, except for mutual funds. Normally, tax-free munis yield about 80% of Treasuries. With no Federal taxes due on muni coupons, the lower return makes the choice between munis and Treasuries a near wash. This slightly favoring the muni, since most buyers are in a 35% tax bracket, not 20%. This is what makes President Obama’s proposal six-months ago to tax wealthy investor’s returns on munis such a joke. This would not have the effect he was desiring, since it would serve to crush the market value of existing bonds, and drive up the borrowing costs for every municipal bond issuer as they would be forced to fill the tax gap with yield, not with Joe Fat Cat wealthy investor simply writing a bigger check to Uncle Sam. Furthermore, the 100-year-old sacrosanct tax-favored status for municipalities would be forever shaken. He obviously did not think that one through.

So to put the current advantages in perspective, let’s look at current yields. Since January of this year, ten-year muni yields have dropped from 2.4% to 2.1%, and thirty-year yields have dropped from 4.35% to 4.15%. During that same time frame, 10-year Treasury yields have dropped from 2.3% to 1.6%, and thirty-year rates from 3.45% to 2.7%.