February 11, 2011

The Municipal Bond Trade, Part II: Is Now the Right Time to Buy?

My most recent blog posting focused on a recent PIMCO conference call where Robert Narens explored the municipal bond asset class.  In PIMCO's view, municipal bonds have priced in significantly more risk of default than what actually exists.  So is it time to buy?

The fundamentals are certainly interesting. The 30-year yield of the Municipal Market Daily Index (MMD, a gauge of AAA yields in the muni space) is actually higher than that of Treasury bonds of the same maturity. Considering the tax benefits of munis, this spread makes no sense.

Historically, 10-year AAA-rated muni paper trades at around 87% of the yield of Treasury notes of the same maturity. Today, the two are nearly at par.

Buying opportunities certainly exist in certain types of muni bonds, including high-quality non-rated land-secured offerings, zero coupon bonds, and improving credits rated BBB and A.  But unless advisors have in-depth knowledge of the vagaries of the municipal marketplace, they are better served using a specialist, according to Paul Touchstone (left), senior investment strategist and portfolio manager at San Francisco-based Stone & Youngberg.  His firm is the largest muni underwriter in the western U.S. and helps a variety of advisors with muni portfolio construction.

A more holistic approach to gaining muni exposure is through closed-end mutual funds. These funds are listed securities and can trade at a  premium or discount, depending on investor sentiment. Based on such information from www.cefconnect.com, a free website, the discounts on such funds are around 4% to 5%. That is not a sufficiently attractive enough spread for me to pounce, but we will monitor on an ongoing basis.

[Patrick Galley, a blogger for AdvisorOne, is chief investment officer for RiverNorth Capital Management, which compiles its own closed-end fund index.-Ed.]

The one scenario that could make the muni market cheaper is more supply.  No one knows when issuance might increase–municipalities know that spreads are blown out and are waiting–but if supply increases the market may get even more attractive to buyers. Stay tuned for more. 

Disclosure:  QES receives fees on client assets introduced and managed at Stone and Youngberg.  However, QES does not receive commissions or fees from municipal bond transactions.

 

Read more from Ben Warwick on municipal bonds:

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