I. WHY DO INVESTMENT OPPORTUNITIES ARISE?
Municipal bonds offer an interesting investment opportunity – one that could deliver double digit gains while at the same time US Treasuries are actually losing money. Such opportunities don’t come around very often, and when they do, they are characterized by markets or market-segments reaching extreme relative valuations as a result of significant dislocations within the macro economy, geopolitics, or investor preferences. Today, we benefit from three such dislocations – one each, from each of these three spheres:
- Coordinated global governmental intervention within the fixed-income markets designed to drive interest rates on treasury-issued debt significantly below equilibrium levels,
- Not coordinated, but instead coincident, global governmental actions to raise marginal tax rates or to impose massive tax rate uncertainty, and
- A temporary, but nevertheless potent, shift in investor preference favoring portfolios with greater liquidity and lower risk – as a result of the most severe and longest lasting disruption in global equity markets since WWII.
Collectively, these three forces have left several segments of the investment arena significantly dislocated – one relative to the next. As a result, several unusually attractive investment opportunities present themselves. Let us dig into the data and uncover the nature of these investment opportunities.
II. TODAY’S OPPORTUNITY WITH MUNICIPAL BONDS
Recall that Treasury interest rates peaked back on 12/11/1980 with the 13-week US Treasury Bill paying 17.14%. Today, this same instrument pays only 0.07%. The longevity, consistency, and magnitude of this interest rate collapse was unprecedented in our nation’s 200+ year economic history. However, unlike Treasuries, municipal bonds have had a tough slog of it ever since the beginnings of the global financial debacle (initiated back in 2007). Specifically, municipals have been undermined by three powerful factors over the last six years:
- Increased probability of default (although, it still remains remarkably small),
- Loss of liquidity (widening of bid/ask spread and increased cost, decreased speed, and decreased size of a trade), and
- Increased tax rate uncertainty (uncertainty regarding the deductibility of municipal interest and the level of marginal tax rates).
Let’s explore the data describing the relative valuation between Treasuries and investment grade municipal bonds of identical maturities. Traditionally, municipal bonds trade at lower interest rates than Treasuries. This is because they are tax-exempt. On an after-tax basis, munis offer a higher yield. However, Mr. Market insists that munis provide a slightly higher yield than after-tax Treasuries in order to compensate for their slight probability of default and decreased liquidity (in addition to the government’s propensity to periodically and unpredictably change tax law). The most popular measure for comparing these two instruments is to take identical maturities and select only those municipal bonds of the highest quality level. Next, an implied marginal tax rate is calculated that results in equivalence between the after-tax Treasury yield and the muni yield. Between early 1953 (when data first became available) and late 2007 (the beginning of the global financial debacle), the implied marginal tax rate that brought munis and Treasuries into equivalence was approximately 15%. For example, if Treasuries were yielding 10% then Mr. Market would price munis so that they would yield 8.5% (8.5% = 10% x [1 – 15%]).
But with the advent of the financial crisis, muni bonds were pummeled. Today, the implied marginal tax rate is actually negative. This is counterintuitive and implies that the government pays us instead of us paying them. Nevertheless, as of 12/31/2012, Mr. Market is pricing munis such that the implied marginal tax rate is -41.03%. This is a staggering development and highlights the potential magnitude of the relative investment opportunity, i.e., munis versus Treasuries.
A dislocation of this magnitude last occurred during the Great Depression, but quality data is difficult to obtain. The closest similar event to have arisen within the last 60 years occurred in mid-1986 when the implied marginal tax rate fell to -3%. At that time, municipal bonds were temporarily distorted in their pricing as a result of a weakening economy. However, the primary driver behind their relative decline was the passage of the Tax Reform Act of 1986 that reduced the top marginal tax rate from 50% down to 28%. Would this have been a favorable entry point for municipals? During the subsequent fourteen months (06/30/1986 – 08/31/1987), Treasuries lost money, returning -1.9%, while munis gained, earning +11.4%, for a relative muni gain over Treasuries of +13.3% . In other words, it was an outstanding time to shift away from Treasuries and towards munis. Based on the magnitude of today’s dislocation, the investment opportunity should be even greater today.
In terms of maximizing this opportunity, the question arises as to what maturity provides the greatest potential profit. As of 01/18/2013, the 20-year maturity provides the greatest bang for the buck. Treasuries of this maturity were yielding 2.65%, while taxable equivalent AAA muni yields were at 4.61% (as based on a 35% tax bracket).
III. AN EVEN GREATER OPPORTUNITY WITH UTILITY STOCKS
But municipal bonds are not the only opportunity. Historically, a tight and relatively stable relationship existed between munis and dividend paying utility common stock. This relationship has also become distorted – and in a fashion that makes utilities more attractive than munis. Again, let’s examine the data.
Historically, municipal bonds have yielded, on average, 104% of the after-tax yield generated by utility common stock . But today, this relationship is also inverted. As of 01/18/2013, munis are yielding only 56.5% of the after-tax yield provided by utility common stock. As with the Treasuries versus munis, this inversion is unprecedented from a historical perspective. The last time we saw something even remotely similar was back in mid-February, 2003 when the ratio had fallen to 75.5%. Over the subsequent 14 ½ months (02/14/2003 – 04/30/2004) utilities returned 38% while munis earned only 3%. This would have been an outstanding entry point for overweighting utility common stocks relative to municipals. Even more interesting, this period paralleled today’s environment in a number of different ways. Just as with today, back then, the economy had just risen from out of a deep recession (ending in November 2001) and then proceeded to grow at an inordinately low, almost halting rate for the next 2 ¾ years. Moreover, today’s environment may be even more attractive for utility common stocks relative to municipals for the following reasons:
- The US is experiencing a strong resurgence of manufacturing across several industries (thus benefiting utilities),
- Industrial production is growing strongly – far more strongly than during the average recovery since WWII (again benefiting utilities), and
- The anticipated future long-cycle decline of the US Dollar will benefit exporters (thus further aiding domestic manufacturing and utilities).
IV. STRUCTURING YOUR CLIENT’S PORTFOLIO
So how might one structure a client’s portfolio to take advantage of these robust dislocations? The most conservative approach would be to overweight municipal bonds by going long the muni ETF with symbol MUB (iShares S&P National Municipal Bond Fund). If the client prefers a slightly less conservative approach, then a short on Treasuries could also be installed via a long position using the Treasury ETF with symbol TBT (UltraShort Barclays 20+ Year Treasury Profile). By adding this short Treasury position to the mix, one reduces or even eliminates the risk of rising interest rates. Finally, the most active portfolio position could be achieved by being short Treasuries and long utility common stock. For this position I would suggest using TBT and then obtaining ETF utility exposure with symbol XLU (SPDR Utilities Select Sector Fund).
No matter what the client’s risk tolerance, now would be a favorable period to make use of municipal bonds (over Treasuries) for clients in the highest marginal tax bracket. And for those seeking to simultaneously exploit the two very sizable dislocations identified above, shorting Treasuries with TBT and going long utilities with XLU could be a very attractive addition to any portfolio.