The Rally Nobody Noticed: Municipal Bonds

Historically, in terms of yields, because of their federal tax exemption, AAA-rated municipal bonds have traded at a discount to Treasuries. Over the long term, AAA-rated intermediate-term municipal bond yields have typically traded between 75-85 percent of the yields on similar maturity Treasuries. For example, for most of the period from 2001 through 2007 five-year Treasuries yields traded between 70 percent and 85 percent of the yields on five-year AAA-rated munis. And they never rose above 100 percent.

The financial crisis that began in late 2007 changed all of that. For a long time the flight to the higher quality and greater liquidity provided by Treasury bonds led municipal bond yields to be even higher than Treasury yields. The peak of the flight to safety came in early 2010 with municipals yielding as much as 160 percent of Treasuries.

Even after the worst of the financial crisis was over, municipal bond yields continued to trade at a premium. One reason was the now infamous forecast made by Meredith Whitney which “spooked” many investors and led to a massive exodus by retail investors from municipal bond funds. On December 19, 2010, while appearing on 60 Minutes, Ms. Whitney predicted a wave of defaults that would occur in the municipal bond market in 2011: “You could see 50 sizeable defaults. Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars’ worth of defaults.” We know now that not only did municipals experience very few defaults, but municipal bond funds continued to produce good returns. We can see this by comparing the returns of the Vanguard Intermediate-Term Tax-Exempt Fund (VWITX) with an average duration of 5.4 years with the returns of the Vanguard Intermediate-Term Treasury Fund (VFITX) with an average duration of 5.2 years. Keep in mind that the returns are total returns and are pretax returns. Data is from Morningstar.

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