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Munis Today: Lots of Yield, without All the Risk

High-quality munis lack the flair, but not the appeal.

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Last year was a stressful year for many bond investors. Concern over defaults in subprime-mortgage-backed securities, initially contained to that corner of the fixed-income arena, eventually burst into the rest of the bond market, as market liquidity dried up and most bonds' yields rose. That hurt the value of current bondholders' securities. Treasuries were one of the few--if not the only--safe havens during this time. (Over the 12-month period ended Feb. 13, 2008, the yield on the 10-year Treasury fell by about 1%.) We continue to receive questions from the press and subscribers about which areas of the bond market look attractive now, and we keep coming up with the same answer that we did in fall 2007: munis.

An Imperfect but Useful Comparison
Munis don't make for the easiest of comparisons. But one factor that we can accurately assess is their credit risk versus those of other fixed-income asset classes. For example, the default risk of U.S. Treasuries is virtually nil, so they're less risky than munis. But high-quality munis are a safer bet than corporate bonds. So, to start our comparison, we put the highest-quality municipal issues side-by-side with Treasuries. And because only a small percentage of investors and managers buy only Treasuries without diversifying into other government-backed paper and U.S. corporate bonds, we also looked at AAA munis' attractiveness versus a handful of well-known, AAA rated corporate issuers.

The 10-year Treasury yields about 3.8%, while a representative AAA muni yields 3.4%. However, on a tax-equivalent basis, the muni's yield jumps to 4.7% for those investors in the 28% tax bracket. And for those in the 35% bracket, the yield jumps to 5.2%. At these levels, we think munis' additional yield--taking into account their tax advantages--over Treasuries more than compensates for their modestly increased credit risk. And they're competitive with high-quality bonds from both  General Electric (GE) and  Citigroup (C), which yield about 5.2% and 5.5%, respectively. (Try out our muni tax calculator to find out more).

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Andrew Gunter does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.