Today's tax-exempt municipal market and America's changing demographics give investors a chance to get in on the municipal bond market. Remember the old supply-and-demand rule? When demand exceeds supply, prices begin to rise until consumers are no longer willing to pay the asking price. This principle applies whether you're talking about groceries, cars, or stocks and bonds. Let's look at both sides of the equation.
On the demand side, consider the baby boomers, which account for nearly one-third of all Americans. Whenever the boomers arrive on the scene, they increase demand. First it was the diaper industry, then they flooded the school system. As the boomers head toward retirement, they'll continue to dominate the scene.
The first of the boomers will reach age 65 in 2011. As investors age, many increase the percentage of their portfolios in fixed-income investments; boomers will probably be no exception. While many kinds of fixed-income investments are available, only municipal bonds offer the exemption from taxes that these retiring investors could use to maximize their after-tax returns. Unlike previous generations, the boomers are expected to have accumulated more wealth than any preceding generation and may invest in municipal bonds in droves, sharply increasing demand.
On the supply side of the equation, consider the municipal market itself. The available supply of tax-exempt municipal bonds has been shrinking in recent years. In the three-year period ending in 1996, new municipal financings totaled approximately $603.4 billion, while bond redemptions totaled $875.5 billion. This means that $248.2 billion worth of municipal bonds disappeared from the marketplace during this three-year period. Taxpayers have also become reluctant to pass bond referendums, so no one is expecting a rash of new financings in the near future. Market analysts predict that new issuance will remain relatively constant, in the $190 billion to $200 billion per-year range, over the next several years.
What does this mean to investors? The potentially growing demand and shrinking supply should result in municipal bonds trading at higher relative prices than we're currently experiencing. Over the past 15 years, yields on municipals (measured by the 20-year Bond Buyer Index) have ranged from 77 percent to 86 percent of the 30-year Treasury bond. If demand from baby boomers sparks the municipal market, the relationship between munis and Treasuries could move into the 70 percent range. Today's municipal buyers could have a tax-free, interest-paying, highly demanded investment on their hands. And at these projected levels, munis would still be attractive to anyone in the 28 percent or higher federal tax bracket. One catch: They won't be as attractive as they are today at an 83 percent-plus relationship.