Executive Summary
As financial planners, we've all heard the old saw "never put a tax shelter inside of a tax shelter" - in other words, don't buy tax-exempt municipal bonds inside of a tax deferred retirement account like an IRA or Roth IRA.
Well, it seems that "never" may have just arrived. Because in an environment where the outright yield on municipal bonds is better than taxable bonds, it really can be appropriate to own a muni bond inside of an IRA!
Owning Municipal Bonds In A Tax-Deferred IRA
Technically, there's absolutely nothing wrong with holding a tax-exempt muni bond inside of a retirement account.
The point of the traditional rule of thumb that you shouldn't is simply that the yields on tax-exempt bonds are nromally lower than the yields of comparable taxable bonds (all else, such as maturity and credit rating, being equal). This is actually a logical reaction of the market, where bond buyers are willing to accept lower yields because their after-tax take home income may be comparable.
Example. An investor in a 35% marginal tax bracket can invest in 3.5% tax-exempt municipal bond, and actually earn more on an after-tax basis than buying a taxable bond yielding 5% (which returns only 3.25% after taxes).
From the bond issuer's perspective, being able to issue a tax-free bond a boon, because the borrower can receive lower borrowing costs by finding investors willing to accept the lower yields. This is why the preference is provided to (and only to) municipalities under the Federal tax code; it's a tax subsidy to improve the ability of municipalities to borrow money in the markets, but is carefully doled out to only municipalities.
This traditional market structure - where municipal bonds maintain a lower yield, due to investor willingness to accept lower yields because of the tax-free nature of the interest income - has been a staple of the municipal bond market. Until the recent turmoil in the credit markets.
When Municipal Bonds Yield More Than Treasuries...
In today's marketplace, though, as seen from the current yield information posted on Bloomberg, the yield structure has become distorted by the recent rampant price increase of Treasuries (and the concomitant fall in yield), combined with the heavy selling in many municipal markets (allegedly due primarily to hedge fund deleveraging). As a result, at many maturities of ostensibly similar credit quality, municipal bonds are actually providing a higher yield than taxable government bonds!
Not only can this be a tremendous opportunity to purchase municipal bonds in taxable accounts - why buy a 2-year Treasury at a 1.5% yield when you can buy a comparable municipal bond at a 2.5% yield, especially when the latter is tax-exempt - but as mentioned earlier, it is creating a unique opportunity for IRA accounts. In an environment where the outright yield on the municipal bond is higher, in theory today's environment provides a unique opportunity to turn decades of investment rules of thumb on their head, and buy a municipal bond inside of the IRA to capture the higher yield!
Of course, one does still need to be very wary of this strategy, for several reasons. First of all, almost by definition, a higher yield on municipal bonds implies that there is higher risk in those markets that the market is pricing in, and thus the higher yield may simply be the result of taking on more risk, not an opportunity for a better risk-adjusted return. However, the unique selling in the municipal bond market is being called by some not an increase in risk premia, but simply "the dislocation of a lifetime" as stated by George Goncalves, an interest-rate strategist at Morgan Stanley. With hedge funds deleveraging (where they often have to sell the "good" securities because no one will buy the bad ones), an immense amount of temporary selling pressure have pushed prices down (and yields up) to artificial levels not supported by any actual changes in risk. In reality, though, only time will reveal whether the municipal bond market yields are really a reflection of changing risk, or just a temporary dislocation that is resolved once enough dollars become available to absorb the selling pressure. And in an environment where municipal bond insurers still appear to be at risk, some credit analysis is still as important as ever (perhaps even more important!) when making investing decisions.
Beyond the potential investment risks in the municipal markets, be cautious that there is also still a lot of opportunity for confusion here. Although in the immediate short term, yields on municipal bonds may be higher than comparable government bonds, at some point this unique situation will likely revert back to the "normal" environment where current yields are lower on municipal bonds. At that point, a client pulling out a statement (or an accountant reviewing a client's tax situation), may question why municipal bonds are being held in a retirement account, potentially damaging the financial planner's credibility and trust if the situation cannot be properly explained. Perhaps this means that some firms will have to be extra-proactive to communicate the opportunity and the reasons to clients. Other firms may simply decide that the difference in yield isn't worth the potential public relations challenges.
Nonetheless, from a purely analytical perspective, it does appear that for once, we may have reached the situation where a tax shelter really should go inside a tax shelter, because a good yield is still a good yield!
