Fed twist makes tax-free bonds pay off for rich

The Federal Reserve’s plan to drive down lending rates by buying long-term Treasuries is helping make tax-exempt bonds more profitable for wealthy investors.

The BGOV Barometer shows that top-rated 30-year tax-exempt bonds yielded 96 basis points more than 30-year U.S. debt yesterday, a difference almost three times the average for 2011. A basis point is 0.01 percentage point. The yield on 30-year Treasuries fell as low as 2.7 percent on Oct. 4, the least since January 2009, after Fed’s so-called Operation Twist was announced Sept. 21.

The difference in yields means investors in the top 35 percent income-tax bracket would have to earn 6.25 percent taxable to match yesterday’s 4.06 percent 30-year tax-exempt yield, according to data compiled by Bloomberg. Those paying 28 percent would need 5.64 percent.

The average yield on the 30-year tax-exempt security equaled 120 percent that of similar U.S. debt yesterday, according to data compiled by Bloomberg. That’s the most in more than two years and contrary to the historical norm, in which tax-exempt bonds yield less than taxable Treasuries.

Increased borrowing by state and local governments, tepid demand for their securities and talk the tax exemption of municipal debt may be scaled back are responsible for the inversion, said Alan Schankel, director of fixed-income research for Janney Montgomery Scott LLC.

That’s a buying opportunity, he wrote to clients last week.

“History has smiled on investors” when high-quality municipal-bond yields have “significantly” exceeded those of taxables, as they do now, Schankel said.

“Cyclical high ratios warrant some switching of fixed- income assets from taxable to tax free,” he said, because AAA municipals will outperform Treasuries in coming months.

(For more information on Bloomberg Government, visit bgov.com.)