During the past couple of months, several events have made municipal tax-free bonds very attractive compared with taxable government and corporate bonds.
One major event has been the huge supply of tax-free bonds that has flowed into the marketplace since the passage of the Deficit Reduction Act of 1984 in late June. At the same time, the absence of buying by fire and casualty insurance companies, always one of the major demand forces in the market, has made it more difficult for muni rates to decline in the face of a general move to lower interest rates.
Also, during the election campaign, there was a great deal of rhetoric concerning tax changes, a move to a flat tax, and so fourth. This uncertainty may have contributed to a slower reception of tax-exempts by buyers.
Last week, the Treasury unveiled its proposed new tax program, which featured a 35 percent maximum tax. Under that proposal, a tax-free yield would be worth less. A 10 percent tax-free yield is currently the equivalent of a 20 percent taxable bond for an investor in the top 50 percent bracket.
For an investor in the 35 percent bracket, that 10 percent tax-free yield would be the same as a taxable equivalent of 15 percent, a difference of 500 basis points. (A basis point is 1/100th of a percentage point.) Regardless of the tax situation, there still are not any 20 percent or 15 percent taxable government or corporate bonds around.
The result of these various events is that the ratio of the tax-free yields on high-grade municipals as well as A-rated revenue municipals to the yields on comparable government issues has risen to extremely high levels.
As of Nov. 29, the ratios of AAA-rated munis to governments were as follows: 0.59 for one-year maturities, 0.67 for five years, 0.76 for 10 years, 0.83 for 20 years, and 0.85 for 30-year issues. In late August, those ratios were 0.52 for one-year issues, 0.60 for five years, 0.69 for 10 years, 0.76 for 20 years and 0.77 for 30-year issues.
At the same time, in the revenue area, the ratio of Bond Buyers' long revenue bond index to the 30-year government is now about 0.94. In August, that ratio was 0.83.
Further, the ratio of A-rated "power authority" revenue bonds to long governments is now about 0.96. Typically, this relationship has been between 0.80 and 0.85.
The bottom line is that at this time, with the present tax structure, municipal bonds are cheap compared with taxable bonds. Historically, when similar imbalances have arisen, they have been corrected, usually with the prices on tax-frees advancing and their yields declining.
From another angle, when looking at the yield curve on high-grade munis, we find there is a 390-basis-point spread between the one-year and the 30-year bond. Over the past two years, the slope of that yield curve has averaged about 350 basis points. Consequently, in the face of a rally, a major move would occur in the longer maturities as the curve snaps back to the average of 350 basis points -- certainly something to consider.