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Munis Still Attractive

David R. Kotok
Tue Feb 6, 2024
By now, readers are familiar with the chart structure below.   It is used to compare an actual municipal bond, the federal agency yield curve, and the US Treasury yield curve.  
The unusual market anomaly it depicts has been with us since the beginning of last year and started when the first political crisis evolved as a few members of the House held up the budget and threatened a federal default. That debt-ceiling fight has permanently altered credit spreads.  It has raised the CDS (credit default swap) insurance cost on the United States.  It triggered a second credit agency downgrade of the US.  And it also resulted in the market price changes of the type you now see in the chart below. 



  The recent congressional continuing resolutions have slightly dampened the extremes, but most of the extraordinary spread is still in the marketplace. Credit default swap pricing is not as severely worrisome as it was at the worst, right before the McCarthy-Biden handshake in May of last year. But it is still very elevated. Thus, mortgage interest rates are still higher than where they would otherwise be if none of this political culture war behavior existed. And a new buyer of a home financed with a qualified agency mortgage is still paying more per month than they otherwise might pay in my opinion. The penalty for the extreme position in the US House of Representatives is imposed on that home buyer, in my opinion.  
On the other hand, in my opinion, the benefit of higher interest rates flows to the buyer of a tax-free municipal bond even as it adds to the expenses of the municipality or issuer. The bond buyer gains. The House of Representatives’ failures to pass continuing budgets until the last minute is the reason.  
In the chart below you will see the updated depiction. This is not an estimate or theoretical depiction.  This is an actual trade.  Cumberland was able to obtain the 30-year Nebraska Housing AAA-rated tax-free bond for a client. The initial yield was 4.8% tax-free. You can see that is about the same as the actual taxable federal agency yield at the 30-year maturity. Thus, at the 30-year maturity, the income tax code arbitrage for a tax-free municipal bond was essentially ignored in the market pricing.  
Note that the housing agency bond has a prepayment methodology, so it can accelerate if the mortgages pay off faster than anticipated. All mortgage-related securities have that characteristic.  
But the bond holder is getting well paid for the prepayment acceleration risk, in my opinion.  The bond is paying the bondholder tax-free interest at a rate higher than obtained on taxable federal securities of longer term. And the credit backing of the bond is clearly AAA and contains powerful covenants to protect the bondholder. This is a federally backed conduit, tax-free security. As I said, we bought this bond for an actual client in their separately managed account.  
Here’s the chart.  


David R. Kotok
Co-Founder & Chief Investment Officer


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