The big opportunity in these tax-free bonds may be short lived — 'the ship is leaving the port,' says strategist

CNBC

2 days ago

The opportunity to scoop up municipal bonds at attractive prices isn't going to last forever, according to strategist Tom Kozlik. The head of public policy and municipal strategy at Hilltop Securities has been warning investors that a " window of opportunity " may close fast once the idea that the Federal Reserve is destined to cut interest rates gains in popularity. Now, he's seeing signs that may have started. "The ship is leaving the port, and investors should stay alert to avoid missing this opportunity," Kozlik wrote in a note last week. Yields on municipal securities declined recently, reinforcing this view, the strategist noted. July's disappointing jobs report , showing signs of a potential slowdown , further strengthened the argument. Bond yields move inversely to prices. Plus, recent economic data, Traders now see a about an 86% chance of a September rate cut by the Federal Reserve, according to the CME FedWatch tool , which uses 30-Day fed funds futures prices to determine the odds. "A combination of either the market and/or the Fed could cause yields to drop, further closing that window of opportunity," Kozlik said in an interview with CNBC. The average municipal bond yielded 3.9% late last week, down from 4% the week before, helped by a rally in the Treasury market, said Cooper Howard, fixed-income strategist at Schwab Center for Financial Research. For instance, the Schwab Municipal Bond ETF recently had a 30-day SEC yield of 3.78% and a 0.03% expense ratio. SCMB YTD mountain Schwab Municipal Bond ETF year to date Those yields are before taxes are taken into consideration. Interest earned from muni bonds is free from federal tax and, if the bond holder lives in the state where the bond is issued, exempt from state and any local tax too. For investors in the top tax bracket, the tax-equivalent yield is around 6.5%, Howard said. In addition, municipal bond yields are even more attractive on a relative basis when compared to Treasury yields, especially at the longer end of the yield curve, he noted. The municipal-to-Treasury ratio for 10-year bonds is about 75%, meaning munis yield about 75% of what similar Treasury bonds yield. While Treasurys are free of state taxes, they are not exempt from federal taxes. "The longer portion of the yield curve, if you're an investor who can stomach a little bit of interest-rate risk, we think that that can make sense," Howard said. Yet that relative value can soon come down as well, Kozlik said. Over the last couple weeks, cross-over —or nontraditional — buyers have been investing in municipal bonds, he said. "Those non-traditional and non-regular buyers have been pretty active, and when those non-traditional buyers jump in, that's one of the things that oftentimes brings down that relative value," he explained. The municipal-to-Treasury ratio hasn't fallen quickly because there has been heavy primary issuance, he said. "So on the one hand, that means that the opportunity for municipal-to-Treasury ratios being very attractive could continue for a couple of days — but I'm saying days, I'm not saying weeks," Kozlik said. "So this is something that when individual investors see this, they can't wait." Where to find opportunity Kozlik largely recommends high-grade, well-rated state and local general obligation bonds and revenue-authority bonds. "Municipal credit is still very, very strong," he said. "It's stronger than it was before the Covid crisis." In addition, there can be some value found in beat-up higher-education bonds , he said. While some in the sector are suffering, bonds from a large state system or large organization that isn't having an enrollment problem look good, he said. Howard doesn't focus on general obligation bonds versus revenue bonds, or any specific sector over another. "It's important to look at what is backing that bond, and where are they driving their revenues from," he said. Creating a ladder of varying duration can also make sense, he said. He suggests an average duration of six years. "It really takes the guesswork out of trying to time interest rates," he said.