Municipal Bonds: Still Undervalued, Probably

We've held a modest weighting in municipal bonds since early March when yields struck far below Treasury yields, despite munis' tax-free status. Investors' flight to Treasuries amid growing credit crisis resulted in level of muni devaluation that only occurs a few times in a lifetime.

Our position in munis was modest, because we worried about the tail risk of financial collapse, as we wrote about in our post (Munis Ain't No Treasuries). Municipalities have certainly been known to default, especially when they're playing with complex financial instruments, suffering from sagging property tax revenue, etc. So munis are not a replacement for the "deflation hedge" portion of one's asset allocation. But they can certainly play a role when they're historically cheap.

But munis are still yielding more than Treasuries, as highlighted in a SeekingAlpha update today.

Our reasons for holding munis (we favor Vanguard's long-term tax-exempt funds) remain the same as when we wrote on March 17 (and the position has been working so far): (1) After a big selloff, munis were yielding more than similar-maturity treasuries despite munis' tax-free status, and smart money was buying; (2) Investors anticipating U.S. tax increases in the next administration saw the advantage of owning muni bonds only rising, and (3) Warren Buffett was reportedly seeing brisk business for the new muni bond insurer he established, and (4) Muni bonds have rallied, showing a healthy reaction to positive developments.