Municipal bonds, however, might address some of investors’ concerns by potentially delivering tax-equivalent yields¹ that are above corporate bond yields, but with less historical volatility than even Treasury securities.² Still, the evolution in the market for tax-exempt bonds in recent years underscores the importance of investment strategies that are capable of providing judicious security selection, continuous portfolio monitoring, and broad access to liquidity.

Historically, the municipal and Treasury markets tend to move in tandem, but recently, munis have lagged behind, and their yields are currently above those on Treasury securities at every maturity. This is an unusual occurrence because the income from municipal securities is exempt from federal income taxes, whereas the income from Treasury securities is not. [It should be noted, however, that the income from municipal bonds may be subject to the alternative minimum tax.]

When the tax treatment of municipal securities is considered, their tax-equivalent yields recently have been above the yields on corporate bonds with similar credit ratings. And this difference becomes greater as investors assume more credit risk. For example, the tax-equivalent yield on a municipal bond index comprised of bonds with ‘AA’ credit ratings was 3.46% for those in the 35% tax bracket (as of June 30, 2012), or 104 basis points (bps) higher than the yield on a corporate bond index comprised of securities with� identical credit ratings. And as one moves to ‘BBB’ credit ratings, the tax-equivalent yield of 6.56% on a municipal bond index was 254 bps higher than the yield on the comparable corporate bond index (as of June 30, 2012).³

Relatively high yields can indicate the presence of additional credit risk. But that relationship may not hold when it comes to the tax-equivalent yields on municipal bonds, because the historical defaults of municipal bonds with investment-grade credit ratings have been exceedingly rare. Indeed, the average cumulative default rate for investment-grade municipal bonds was 0.08% from 1970–2011, well below the 2.61% rate for investment-grade corporate bonds over the same time period, according to Moody’s Investors Service. While the current economic environment has affected many state and local budgets, most municipalities have taken significant steps to preserve their credit quality. These steps have been reflected by 10 consecutive quarters of rising state tax collections, reduced budget expenditures on projects and payrolls, and adjustments to pension plans by 35 states.⁴ Although these improvements demonstrate the flexibility of most municipalities to weather tough economic times, as with most trends, there have been exceptions.

News that a few municipalities recently filed for, or moved toward, bankruptcy has received widespread attention in the media, even though these cities and towns have very little outstanding debt. And the financial distress faced by these municipalities can be traced back to specific events, idiosyncratic structural issues, or a combination of both.

Municipal bankruptcies should remain rare, but it is possible that other highly distressed cities might pursue this route as a way to reorganize. The pockets of distress in the municipal bond market, and the task of identifying them before they become acute, highlight a prominent challenge that individuals might face from investing in the municipal bond market on their own.

Active managers of bond funds, however, can conduct credit analysis to determine the level of strain faced by a municipality, while also monitoring existing investments for developing signs of distress. The need for credit analysis has become particularly important in recent years due to the absence of bond insurance that used to enhance the credit strength of an issuer. Since bond insurers lost their ability to guarantee bond issues, the number of bonds in the market with ‘AAA’ credit ratings has fallen from 70% in December 2007 to 13% (as of June 2012).⁵

There are other recent developments that might also affect an individual investor’s experience within the municipal bond market, especially as individuals tend to access the market via a single securities dealer. In recent years, conservation of capital and a tightening regulatory environment have constrained the bond inventories kept by dealers. As a result of these adjustments, individual investors’ access to the market and their ability to liquidate positions when needed might be limited by a dealer’s inventory.⁶ On the other hand, portfolio managers generally have access to dozens of securities dealers. This access not only enhances the security selection process but it also can improve the cost of trading and the ability to liquidate positions when needed.

The importance of having ongoing access to the broad municipal market is highlighted by the increasing number of refinancings being done by municipalities to lower their interest costs. Refinancing volume comprised more than 64% of the new municipal bond issuance in 2012, up from about 49% in 2011 and 35% in 2010.⁷