How is the Municipal Bond Market Like the Grocery-Checkout Line?

February 14th, 2010

Bonds are big these days. They’ve always been big among fixed-income investors – older people who have begun to prize the return of their money more than the return on their money, in Will Rogers’ immortal phrase. These security-conscious people are also the same kind of people who buy annuities. Nowadays more people are thinking about safety in investments than at any time in living memory.

Municipal Bonds – a Paragon of Bond Safety

Municipal bonds enable cities and states to borrow to finance big projects like roads and bridges. Sometimes municipal bonds are backed by the general revenue collected by the issuing locality. Sometimes they’re backed by revenue raised by the project that the bonds financed. Municipal bonds have always been considered safer than corporate bonds. Governments can raise taxes to finance some muni bonds. Traditionally, the projects undertaken are public goods for which demand is established and from which revenue can reliably be raised.

Which Bond to Buy – Municipal or Corporate?

The difference in risk is not the only difference between municipal bonds and corporate bonds. Interest on municipal bonds has traditionally been paid free of federal tax and also free of tax in the state of issue. That is an advantage municipal bonds enjoy over corporate bonds, whose interest is not tax free. Does this mean people should always buy municipal bonds instead of corporate bonds, since municipals are safer and tax-free?

No, we can’t say that because the interest yields on municipal bonds are lower than for corporate bonds. Well, does that mean you should always buy corporate bonds, because more interest is always better than less? No, that’s not right, either. It turns out that you – and all those other people buying bonds – have a little thinking to do before deciding which kind to buy. Some of us do our best thinking when engaged in tasks unrelated to what we’re thinking about. For example, suppose you go to the grocery store to do your weekly shopping.

The Economics of the Grocery-Checkout Line

When you’ve filled your shopping cart and are ready to check out, do you randomly pick a checkout line in which to stand? No. First, you survey the check stands to see if a manned checkout station is vacant. Failing that, you gauge the line-length at the available check stands and choose the one with the shortest line. Of course, the possibility exists that all lines will be equally long – in which case you will make a random choice.

An economist sees a tendency for lines to equalize in length. There is an incentive to choose a line that is shorter than the others. There is an incentive for people to leave longer lines for shorter ones. People respond to incentives. Their responses reduce the difference in line-lengths. Whenever line-lengths differ, people are motivated to rationally choose a shorter one to save time. The only time they make a random choice is when they have nothing to gain from line selection.

The Equilibrium Position?

Economists say that equality of grocery-checkout line-lengths is the “equilibrium position.” That is because lines are always tending toward equality, although they are not always exactly equal. Even if the lines were never actually equal, this tendency would still exist.

It turns out that there is an equilibrium relationship between municipal and corporate bond interest yields. (We could just as well call it a relationship between bond prices, because it is changes in bond prices that cause changes in their effective interest yields.) The fact that the corporate bond interest is taxable means that its after-tax yield is lower than its nominal yield. There is a formula for calculating a municipal-bond interest yield that equals an after-tax corporate-bond yield. It is:

im = ic (1-t), which implies that ic = im/(1-t),

where i= interest yield, m=municipal, c=corporate, t=marginal tax rate

If the corporate bond yield is (say) 10% and the investor’s marginal tax rate is (say) 40%, then the municipal bond yield with the same after-tax yield as the corporate bond is 6%. Escaping that 40% tax rate is worth exactly 4 percentage points of yield. (If the investor benefits from a double tax exemption – state tax as well as federal tax – then the 1-t term changes to a more complex one,  1- [1- tf [1- ts] ], where f and s refer to the federal and state marginal tax rates, respectively.) Does this describe the equilibrium relationship between municipal-bond yields and corporate- bond yields, when both the municipal bond rate and the corporate rate satisfy the formula?

Equilibrium Between Municipal and Corporate Bond Yields

No, it doesn’t. As mentioned earlier, municipal bonds have always been considered safer, on balance, than corporate bonds. The first rule of finance is the tradeoff between risk and return, so investors should be willing to accept a slightly lower return on municipal bonds in exchange for the absolute safety of their principal. How much lower? We can’t say. The answer depends on each particular investor’s belief about how much safer the municipal bond is and how much that investor values that degree of safety.

We can say this, however. If the two interests yields are equal after tax – if inserting them in the equations above makes them come out equal – then the investor should buy the municipal bond. The effective yields are equal, but the municipal bond is safer, so it dominates the corporate bond in terms of consumer choice.

In such a case, investors will buy municipal bonds in droves. This will drive up the price of municipal bonds and drive down municipal bond yields, bringing the after-tax yields closer to the equilibrium position. The equilibrium position is reached when the purchases of those who favor municipal bonds are exactly counterbalanced by the purchases of those who favor corporate bonds.

The equilibrium principle is the great organizing principle in economics. It applies to stock markets and bond markets and foreign-exchange markets. It applies to choices made by individuals and also by millions of people together in markets. Once you master it, you become more than just a faster grocery shopper. You become an economist.

The Municipal Bond Market in Crisis

Today, many investors seek safety in the traditional refuge of municipal bonds. Ironically, recent events have turned this market upside down and threatened its status as a safe harbor for fixed-income investors. Municipal bonds earned their secure reputation for two basic reasons. First, they were issued by state and local governments. Second, the issuing authority often paid an insurance company to insure the bonds. Investors were willing to pay a slightly higher price, or accept a slightly lower yield, for insured bonds.

Unfortunately, the stability and solvency of some leading bond-insurance companies has been challenged by their holdings of collateralized debt obligations (CDOs), packages of debt securities whose creditworthiness is somewhat opaque. This has, in turn, cast doubt on the value of the municipal-bond insurance underwritten by those companies. Moreover, the solvency and liquidity problems of private individuals and companies have reduced government revenue collections, imperiling the source of interest payments to municipal-bond investors.

Bond insurance is not the last line of defense for safety-conscious investors. After all, not all municipal bonds are insured originally. Like corporate bonds, municipal bonds are rated by bond-rating agencies. Muni ratings are somewhat less reliable, however, because much less data is provided to rating agencies by the issuing authorities than is demanded of corporations.

In a rigorously efficient market, market prices would compensate investors for differences in risk between assets. The highly individual character of municipal bonds and the thinness of trading for most of them, combined with the difficulty of arbitraging away price differentials among municipal bonds, make the municipal bond market less efficient than the market for taxable bonds.

The upshot of all this is that municipal bonds may currently be the exception to the general principle that security of principal is better served by individual issues than by funds. Until the turmoil surrounding CDOs and the bond-insurance companies subsides, investors might be better advised to seek the diversification of municipal bond funds.

Category: Annuities, Economic Analysis, Economic News, Retirement Planning | Tags: , , , ,

Comments are closed.