Tax Exempt Bonds are Today's Best Bond Value

by David C. Blough, Senior Vice President, Investment Management

Bond interest rates have fallen to very low levels. Anyone who has had a bond or certificate of deposit mature since 2008 has had the unpleasant experience of having to reinvest at lower interest rates. Interest rates have been trending lower for nearly thirty years. The early 1980s saw record high interest rates due to very high 10%+ rates of inflation. With inflation fears running rampant, investors could get ten year U.S. Treasury Bonds with 12% or higher interest rates in 1981!

The Federal Reserve, led by Chairman Paul Volcker, slammed the economic brakes on and the U.S suffered a painful two year recession in the early 1980s as a result. The pain proved worthwhile however as inflation was slowly but surely squeezed out of the economy and interest rates began their historic descent. The interest rates on ten year U.S. Treasuries eventually settled into  a 4-8% range from 1990 to 2007.

That all changed with the 2008/2009 economic crisis that resulted in very high unemployment and mild deflation. With too much unused capacity worldwide, a housing market crash and little loan demand due to the financial crisis, the Federal Reserve has pushed interest rates down over the last four years, as it pursues policies designed to spur growth. Today the ten year Treasury pays only  a 1.75% rate of interest!

Investors hungry for yield, have reached for lower quality bonds to provide more income. We believe that quality is important and in today’s market, tax exempt bonds are the most attractive sector to find high quality and still attractive yields. U.S Treasury bond interest is subject to federal income tax, so a 1.75% yield might result in an after tax yield of just 1.25%. With a 2% inflation rate at present, that’s a losing proposition.

Ten year Michigan AA- tax exempt bonds currently pay about 2.5% and are exempt from both federal and state income tax. That means they deliver a return that is double the return on Treasuries. If an investor is willing to extend a bit farther out the "yield curve", a 3.25% rate is available from high quality tax exempts with 15 year maturities. The safety record for AA quality tax exempt bonds is outstanding with extremely low default rates.