In a normal world, municipal bond yields are around 80% of Treasury bond yields. If a 10-year Treasury yields 4%, a high-quality 10-year muni might yield 3.2%. A top-bracket (35%) investor would prefer 3.2%, after tax, from the muni rather than 2.6%, after tax, from the Treasury, but a low-bracket (15%) investor would be satisfied with netting 3.4% from that 4% Treasury.

But today's investment world is far from normal, and muni bond yields may be among the largest aberrations. "Long-term investment-grade muni bonds yield more than Treasuries of comparable duration," says Milton Ezrati, partner and senior economic and market strategist for Lord Abbett in Jersey City, N.J. As of this writing, the 10-year Treasury was yielding 2.77%, according to Bloomberg.com, and 10-year, AAA-rated, general obligation (GO) muni bonds yielded about 3.27%.

This reversal in relative yields makes munis more attractive and more suitable for more clients. "We usually suggest municipal bonds and funds for clients in the 25% tax bracket or higher," says Mark Wilson, vice president at the Tarbox Group, a wealth management firm in Newport Beach, Calif. "Now all our clients can invest in munis. This is an amazing buying opportunity."

Assessing Risks

There are two reasons why munis yield more than Treasuries now. First, the financial panic in the fall of 2008 drove many investors to the safety of Treasuries. "Nervous investors fled to Treasuries," says Stacy Francis, a planner in New York City. "Muni bond prices have plunged and their yields have soared."

Second, economic turmoil has raised fears that muni bond issuers, suffering from falling revenues, might default on their debt. Those concerns, combined with selling from distressed muni investors such as hedge funds, have pulled down prices and pushed up yields.

How severe are the fiscal problems facing muni issuers? "Risks remain significant, but state and local finances in aggregate are not in such bad shape," Ezrati notes. He points out that the ratio of financial assets to total liabilities for state and local governments was 0.915 at the end of the third quarter of 2008. That ratio was down from its peak—1.084 in 2000—but still much higher than the 0.824 level of the early 1990s or the 0.575 level in the mid-1970s.

Today's depressed muni market is pricing in a huge jump in defaults. "According to Standard & Poor's, the cumulative default rate on long-term investment-grade muni bonds has never exceeded 0.15%, even after 20 years," Ezrati says. "Current yields offer an attractive opportunity, even if circumstances were to create unprecedented default rates, which is hardly likely."

Yield Plus

Many planners also feel that the potential rewards of today's muni bond market justify the risks. "Beginning in 2008, when we increased the fixed-income portion of clients' portfolios, muni bonds have been the investment of choice for taxable accounts," says Marilyn Gunther, a partner at the Center for Financial Planning in Southfield, Mich.

Similarly, Rich Moran of Moran, Kimura & Heising, a planning firm in Torrance, Calif., reports that he and his partners developed an "interim recovery strategy" last October. "As part of that strategy, we've had an additional special allocation to very long-term, high-quality munis. It amounts to 20% in all taxable accounts."

Relatively high tax-exempt yields are part of the appeal, along with the potential for capital gains if the oversold muni market bounces back. "Our additional investment in muni bonds is a hedge against the possibility of more widespread deflation over the next year or so," Moran says. "If that happens, we'll have some capital gains as well as substantial income from the special allocation." Deflation probably will mean lower long-term interest rates, pushing up the prices of bonds, including munis.

Some advisors feel that munis may be well-positioned to deliver capital gains. "Muni debt/taxable debt yield ratios remain elevated," says Richard Palmer, director of fixed income at Aspiriant (formerly Kochis Fitz/Quintile), a wealth management firm in San Francisco. "The higher this ratio, the cheaper munis are relative to high-grade taxable debt with similar duration. We expect this yield ratio to fall over the next few quarters, which implies that munis will outperform—not only from higher after-tax yields but also from capital gains."

Here or There?

The toughest choice is between concentration and diversification: Should clients buy local issues for total tax exemption, or should they spread their holdings among many states for risk reduction?

Knowing the math may help planners offer recommendations. To illustrate the tradeoffs involved, here's a comparison of Vanguard Intermediate-Term Tax-Exempt, a national fund, and Vanguard California Intermediate-Term Tax-Exempt. The funds' holdings are similar in credit quality and average effective duration.