Is it Time to Sell Out of Longer Term Municipal Bonds? (PZA, BAB, MUB, TLT)

Longer term municipal bonds with maturities of around 15 years to 25 years looked very attractive at the beginning of the year as Bonds in the space yielded the same or more than comparable taxable bonds. This is a rare occurrence, as normally tax-free bonds yield less than comparable taxable bonds in nominal terms, since after tax municipal bonds look even more attractive. In early January the absolute spreads between AAA general obligation municipal bonds and treasuries were between 0.60 percent and 0.70 percent. This means for roughly the same credit risk (very little) and the same maturity you actually got paid more to buy tax-free bonds vs. taxable bonds. So while the 30 year Treasury bond at the beginning of 2014 yielded about 3.9 percent, the comparable tax free municipal yielded around 4.5 percent. After tax however, this yield advantage actually widened. If you assume a 25 percent tax bracket for an investor the tax equivalent yield of the municipal bond becomes approximately 5.6 percent. The 5.6 percent vs. 3.9 percent tax equivalent spread represented an historically wide yield advantage in holding municipal bonds. But does this advantage still exist, and now that interest rates have come down is it still worth taking the risk to go out that far on the curve? Over the past 8 – 9 months, the spreads certainly have compressed materially. The average difference in long dated municipal yields versus treasury bond yields decreased between 0.30 percent and 0.50 percent since the start of 2014. In addition to the spread compression, overall interest rate levels have gone down by about 0.5 percent to 0.6 percent at longer maturity bonds. This combination has been a perfect storm (in a good way) for long muni bonds, as the asset class is up between 7 and 11 percent through July. So after this impressive run is it time to flee to the ‘safety' of shorter term bonds? Traphagen Financial Group has been trimming the longer dated municipal bonds for some clients in recent months, but we have not exited the position en mass. No question, one should be more cautious at this point while entering a long municipal bond, but the fact that spreads have compressed and rates have decreased should not keep you out of the market all-together. Historically spreads are now average to still somewhat in favor of municipals vs. treasuries, especially in the 20-30 year range. The other danger is the level of interest rates; if they were to move up materially long dated bonds of all types would suffer (as they did in 2013). However if the FED gradually raises the FED Funds rate to 2% or so over the next couple years short term bonds would certainly be affected, but it is unclear how much that would hurt longer bonds (which are less affected by Fed moves). The other factor for all investors to consider is the allocation of their personal portfolio. If an investor has a mostly bond portfolio and therefore is accepting a lot of interest rate risk already, buying long dated municipal bonds should be done with caution. If however the investor has mostly stocks, and little overall interest rate risk (but substantial stock market risk) buying these bonds over a period of time can still be advisable. Some ETFs that offer investors easy access to long dated municipal bonds are listed below. I-shares National AMT-Free Muni Bond ETF MUB gets you a yield of about 2.9% and an average maturity of around 15 years. PowerShares National AMT-Free Muni Bond ETF PZA sports a 4.2% yield with an average maturity of about 20 years. Finally, PowerShares Build America Bond ETF BAB has a 4.1% yield and an average maturity also of about 20 years. It should be noted that BAB is made up of taxable municipal bonds so this ETF should usually be purchased within IRAs. As a comparison, the I-shares 20+ Treasury Bond ETF TLT which has an average maturity north of 20 years and is taxable has a yield of only 3%. Eric Mancini is the Director of Investment Research at Traphagen Financial Group (www.tfgllc.com), which is located in northern New Jersey. Over the past year Traphagen Financial Group has incorporated Chinese investment grade bonds along with its traditional U.S. investment grade allocation.