Ever since the financial crisis, investors have looked to bonds to protect them from the wild fluctuations of the stock market. Yet even as other parts of the bond market have started to show signs of losing ground, the municipal bond market has become more popular than ever. As investors start to focus on the huge looming tax increase slated to take effect at the beginning of 2013, can muni bonds continue to build on their strong past performance?
Why bonds have been hotter than ever
At first glance, interest in bonds seems to make little sense. Interest rates are near all-time lows, which you'd think would dissuade investors from committing their money to bonds.
But when you look at the trailing returns on bond funds, you can understand how inexperienced investors might believe that bonds have much more upside potential than they actually do right now. Long-term Treasuries have actually had double-digit percentage returns over the past five years -- a performance that most stock investors can only dream of. Higher-yielding corporate bonds haven't seen quite such strong returns, in part because the financial crisis sapped investors' confidence about corporates. But especially within the junk bond realm, the more plentiful income available from corporates has drawn attention from those who are hungry to produce cash from their portfolios.
Reversal of fortune
The dynamics of the bond market have changed recently, however. Funds that own high-yield corporates have seen massive outflows, while funds owning municipal bonds have seen inflows in 24 of the past 25 weeks.
One reason for that disparity comes from supply and demand. In the corporate arena, companies are issuing debt as quickly as they can. United Technologies
By contrast, the supply-and-demand situation for municipal bonds is much more supportive of higher prices. Many municipalities face challenging budget situations and are therefore cutting back on issuing debt, leaving the muni market with more debt maturing than new issuance can replace. The resulting shortage of muni bonds has pulled yields down to extremely low levels, in some cases approaching record lows. Even lower-rated muni debt has seen yields plunge, with spreads compared to high-grade muni bonds shrinking to their lowest levels since 2009.
A taxing decision?
Another reason why investors are flocking to munis has to do with the tax environment. With the top tax bracket slated to rise from 35% to 39.6% at the beginning of 2013, the after-tax yield that munis provide will be equivalent to a higher pre-tax yield. Yet right now, municipal bonds throughout the maturity curve actually yield more than Treasuries of comparable maturities. That counterintuitive state of affairs suggests that munis are still a good value compared to Treasuries despite their recent run-up.
Of course, the extra yield that muni bonds pay right now probably comes in part from concerns about risk. Several municipalities have had public problems in repaying their debt, with previously unknown areas like Jefferson County, Ala., becoming warning signs of possible mass defaults on muni bonds. Yet despite calls from Meredith Whitney that the muni market would sport a big rise in defaults, her predictions so far haven't come to pass.
Look at munis
If you need bonds in your portfolio -- and most people need at least some -- then taking a look at munis may make sense if you're in a high tax bracket. The iShares S&P National AMT-Free Muni ETF
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Fool contributor Dan Caplinger is for anything that brings lower taxes. You can follow him on Twitter @DanCaplinger. He doesn't own shares of the companies mentioned, although he does own funds that hold muni bonds. The Motley Fool owns shares of IBM. Motley Fool newsletter services have recommended buying shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is never taxing.