Friday, September 13, 2013

Not A Positive Sign For The Health of State and Local Governments

Traditionally, municipal bonds have had lower yields than corporate bonds because many (although not all) munis are exempt from both federal income tax, and state income tax for the state in which the political entity exists.  (Certain categories of munis that are "private activity bonds" are not tax-exempt, and to add to the confusion, I understand that Puerto Rico munis are exempt from not only federal income tax, but state income tax in every state -- probably because of the weird legal status of Puerto Rico.)

Why lower yield?  Because you are not going to pay federal income tax on the dividends, and if you are a resident of the state from which the bond comes, no state income tax.  A 5% yield on a tax-exempt muni is better than a 5.5% yield on a corporate bond for most taxpayers.

But I see that this is not the case now.  There are a lot of A-rated munis with higher yields than A-rated corporate bonds.  I think some of this is an expression of perceived risk from the munis, especially the high yielding munis from California, Illinois, and New York.

If you have not looked at bonds in a year or two:


Yes, a 5.062% yield on a federal government agency bond.

It might still make sense (when the yields improve a bit more) to start buying.  Yes, there is substantial inflation risk, especially if the economy recovers.  But I think there is also substantial possibility that the economy will continue limping along, barely recovering, if at all.

UPDATE: Here is an Idaho bond, not spectacularly rated:

ActionStateRatingsDescriptionCouponMaturityQtyPriceMinMaxYTMYTW 2TaxableCallableAccrued
Total Cost
03/01/2022 @ 100.00000Continuously-Callable

But note the yield to maturity is 5.242%, and it is exempt from both federal and Idaho income taxes.  It is continuously callable, meaning that the issuer could at any time after 3/1/22 withdraw them, but only by paying off the face value of the bond.

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