Why corporate bonds are still expensive

Think fast: what yields the most, municipal bonds or corporate bonds?

It used to be the case that munis yielded less, since they have the benefit of being tax free -- Federal and oftentimes state too. So investors typically pay more for them, which then brings their yields lower. Also, many muni bonds are backed by state taxes, and the state can always raise taxes to cover their interest expense. Which mean munis in general are a lot safer than corporate bonds -- in general, there are many exceptions of course.

These days, for reasons that I don't understand, Muni bonds in California are yielding a lot more on an after-tax basis than corporate bonds, when comparing similarly-rated credit scores and maturity.

In fact, the spreads are so out-of-whack that I can get a safer (higher credit rate) Muni right now for a much better after-tax yield than a corporate bond with similar maturity.

Just for fun, I checked out a few high-yielding California Munis. Consider this:

California St Var Purp, 2034 (CUSIP:13062R3Y2) was recently seen trading for $80-$89 for an yield of 6.13-5.4%. Not bad for a tax-free return.

A few more:

San Gorgonio Mem Healthcare Dist Calif Go Bds, 2031 (CUSIP: 13062R3Y2) $80-89 6.13-5.4%, rated A3 by Moodys.

California St Go And Go Refunding Bds, 2036, (CUSIP: 13062TSB1) $83.454 5.684%, rated A2 by Moodys and A by Fitch and S&P.

To get a 6% yield after tax, one needs an yield of at least 6/(1-.28) = 8.33% pre-tax. And that's only considering a moderate tax bracket of 28% and no state taxes.

A more reasonable tax bracket for a California investor in the upper tax brackets would be 33% + 9.3% = 42.3%. So, to get an after-tax yield of 6% on that basis one would need to find a bond yielding upwards of 10%.

But let's be conservative and require a 9% yield. What can I find with that kind of yield?

Well, mostly only financials. Here are some issues:

Citigroup Inc, 2012 86.631 9.187 A3/A
Viacom Inc, 2036 77.03 9.191 Baa3/BBB
Bank of America, 2013 84.498 9.202 A3/A-

So, while it's not impossible to get a good deal on corporate bonds, one needs to be really careful to:
  1. Pick a maturity that you're comfortable with. Don't expect the market to fully value your bonds soon. If you can't wait for maturity, don't buy it!

  2. Be wary of credit ratings of financials. Financials are really a black box these days. While the Fed is currently backing them up, they may not do so forever. Or they might split banks apart and you may end up owning the debt of the "bad" part.

  3. Stick with G.O. bonds. As I mentioned before, General Obligation bonds are backed by state taxes and hence are generally safer. Be careful with some kinds of non-GO bonds which are not even issues by the state, but merely use the state as conduit to reach the bond market. These are the worst, usually not backed by anything.

  4. Avoid insured munis. There are issues that are backed by some private company (MBIA, AMBAC, FGIC, etc). Why is this bad? Because if the state is going to default, it will start with those it knows someone else is going to pick up the tab for them.

  5. Avoid low-quality for long-term bonds. Anything below BBB+ (Baa for Moodys) is probably too dangerous to own beyond a year or two, unless you have insight into the company's financial position. Which brings me to...

  6. Do your homework. Look at the terms of the bonds, its seniority, the terms of any sinking fund, call terms, etc. Look at what else the company owes and who the creditors are (if there are lots of more senior bonds than yours you may not get paid in the event of a default). Check the details on the MSRB website.

To summarize: Munis are offering higher yields than corporate bonds, for higher-quality issues and with the backing of a tax authority (for G.O. bonds). No one should invest in corporate America today unless they can find a much better deal with much larger margin of safety.

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