How Markets Work: The Case of Municipal Bond Valuation

Municipal bonds are significantly undervalued in the wake of Detroit’s bankruptcy filing. I am not usually enamored of municipal bonds as municipal financials are notoriously erratic and hard to ascertain. I prefer corporate bonds, where the financials are plain as day, value investing yields a sharper contrast, and one can maximize returns. That said, in the wake of the goings-on in Detroit, you can see how market fear has increased value in the broad category of municipals.

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As the above chart shows, the highest-rated notes and bonds of state and local governments yield more than Treasuries of similar maturity for 1 year through 30 years without having to adjust for tax benefits. Thus, the present pricing of tax-free bonds makes sense only if an investor assumes that the income-tax code of the U.S. is going to be repealed in the near future.

Yields on AAA rated general obligation bonds, backed by the seller’s credit and taxing power as opposed to a specific source of revenue, appear in the chart. They are typically lower than Treasury yields because their interest is exempted from U.S. income taxes, unlike payments on federal debt.

Top-rated 10-year debt yielded 31 basis points more than comparable Treasuries at the end of last week. Since 2001, the yield has been 30 basis points less on average. Each basis point amounts to 0.01 percentage point.

Municipal borrowers that have the strongest track records are almost as creditworthy as US Treasury bonds. This is a prime example of market fear causing a market failure, which will eventually correct as municipals move back up. Detroit’s problems do not reflect on the broader market, but bond buyers seem to think they do.

Again, this does not mean that I favor municipal bonds. I still find a higher margin of safety in corporate bonds, even when accounting for tax advantages.

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