Something funny happened in the municipal-bond market this week.
Yields on munis didn't just rise above those on Treasurys. A few actually rose above those on corporate bonds as well.
Tom Metzold, manager of the Eaton Vance National Municipal Income Fund, notes that on Wednesday a tax-exempt bond backed by Goldman Sachs actually paid slightly more than a taxable bond backed by the bank.
And that's before counting the tax break on the interest.
No kidding. The 10-year taxable Goldman bond paid 4.51%, gross. The 10-year tax-exempt: 4.61%.
Bloomberg News
Municipal bonds help fund everything from roads to bridges, like this one in California.
It makes no sense. It's crazy. Someone in a top federal tax bracket pays 35% tax on bond interest. So in a perfect market you'd expect tax-exempt bonds to offer about a third less interest than those with the same default risk and duration (and that's not including any applicable state and local tax breaks).
Instead, the relationship has turned upside-down.
"We saw stupid, panicky reactions by some people," says Mr. Metzold. Many retail investors, who play a huge role in the municipal market, dumped their muni funds this month.
Why? Four reasons.
First, they fear the new Republican Congress will ax support to the states—putting embattled state finances under even more pressure.
Second, they hope the Republican victory will mean the Bush tax cuts are likely to get extended—which slightly lessens the appeal of tax-exempt munis.
Third, the market was hit by a wave of new bond issues, notably from California. Too much supply hit prices.
Fourth, they were also reacting to the sharp selloff across the bond market this month—in part the result of Ben Bernanke's new burst of money-printing, which raises inflation fears.
Net result: The iShares S&P National AMT-Free Municipal Bond exchange-traded fund, which traded at $106 late in October, has tumbled to $100.77.
The selloff is producing some peculiarities.
Consider: Ten-year Treasury bonds are yielding just 2.9%. (The yield is especially low because the Federal Reserve's bond-buying program is targeting medium-maturity bonds.) Meanwhile, 10-year municipal bonds of top, AAA-rated quality are yielding about 3.2%—again, tax-free.
Says Paul Brennan, a municipal-bond manager at Nuveen Investments: "Most municipal bonds, particularly at the long end, are yielding substantially higher than Treasurys."
The selloff has hit closed-end funds too. Closed-ends are mutual funds that trade on the stock market like a company share. They are mostly owned by retail investors, who are apt to stampede at the first alarm. Some closed-end funds specializing in municipal bonds have dropped to significant discounts to their underlying net assets. As ever with closed-ends, you need to understand the fund, what it owns and how much it may have borrowed against its holdings.
Make of it what you will. I'll confess I'm wary of bonds right now, because of the risks of inflation. But if I had to buy any, I'd probably be buying municipals. There are opportunities.
Mr. Metzold certainly thinks so. He's hoping this week will be the end of the rout. On Wednesday, he says, he put "a big chunk" of his own money into his fund.
Write to Brett Arends at brett.arends@wsj.com
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