“What should I invest in?” We economists get asked this question all the time. Many members of the profession believe that Efficient Markets theory forbids us from giving an answer – beyond recommending “a well-diversified portfolio.” Perhaps a few of us won’t countenance a question that ends with a preposition. But the rest of us would like to be helpful. Even so, the past year has been a difficult time to give an answer.
One can no longer recommend euros or commodities, as the (somewhat predictable) appreciations there have already taken place, over the last five years. As for equities, corporate bonds, and housing, they have all been measurably overvalued for awhile. Even if one believed that the corrections in those three markets were now largely complete, it would be hard to predict that their rates of return on average over the next 25 years will be anywhere near as great as over the preceding 25 years. But, complains the investor, I have to hold something.
One US asset class strikes me as undervalued relative to the rest: municipal bonds. AAA-rated munis of each maturity pay a higher yield than Treasuries of the same maturity. The differential is as high as 50 basis points for the 2-year and 30-year maturities. Yet state and local bonds are tax-exempt while treasuries and corporate bonds are not. Thus the differential in after-tax rates of return is even larger. (I am only recommending munis for the taxable part of the portfolio of a taxed investor, of course. Put equities in the tax-exempt part.)
The obvious reason why state and local governments might have to pay more to attract investors is risk of default. But it is likely that investors fear default on munis more widely than they should. Default is rare, notwithstanding the long memories left by financial troubles in New York City and Orange County in decades past. (Furthermore, when there is a default, holders of munis usually enjoy a higher recovery rate than holders of corporate bonds.)
Why the misperception on the part of investors? Academic research seems to regard the discrepancy between after-tax returns on munis and corporate bonds as an unresolved puzzle.
But perhaps the answer lies in something so crude as the different rating scales that are applied to municipal versus corporate bonds. The front page of today’s New York Times (“Does Wall Street underrate Main Street?“) reports that state and local officials “complain that ratings firms assign municipal borrowers low credit scores compared with corporations. Taxpayers ultimately pay the price, the officials say, in the form of higher fees and interest costs on public debt. ‘Taxpayers are paying billions of dollars in increased costs because of the dual standard used by the rating bureaus,’ said Bill Lockyer, treasurer of California, who is leading a nationwide campaign to change the way the bonds are rated. ”
Moody’s is completely explicit about the difference in yardsticks. A state bond with a rating of A1, which is four notches below Aaa, would be rated Aaa if it were a corporate bond with the same default risk. A corporate bond rated Ba has a 20 per cent history of defaulting within ten years, whereas a municipal bond with the apparently-same rating of Ba has a default history under 1 per cent.
This is all familiar to knowledgeable investors. But not all investors are knowledgeable. I wonder if this elementary difference in labeling is enough to affect behavior?
In any case, next time I get asked at a cocktail party what to invest in – after the usual disclaimers, including the point that as the economy slows down defaults on state, local, and corporate bonds alike are bound to rise — I am going to say “munis.”