OPPORTUNITY IN TAX-FREE MUNICIPAL BONDS
MBD-4088H-A OCT 2008 Page 1 of 2
To help reduce tax bills each year, many investors buy
tax-free municipal (“muni”) bonds. Current volatile
conditions in the municipal bond market have
provided investors with good and bad news. The bad
news if you already own muni bonds is that the current
value of your bonds has dropped substantially in recent
weeks. The good news is if you’re considering tax-free
muni bonds, rates have risen to attractive levels.
Of course, as bond prices fall, interest rates rise, and
vice versa. Fortunately, these current price declines
generally are not being driven by credit quality
concerns. Overall muni bond credit quality remains
strong. Instead, these declines are primarily the result
of supply-and-demand imbalances fueled by the
current credit crunch. As a result, the price declines
generally aren’t due to issuer-specific problems, but
rather market-related issues that are impacting all
muni bonds.
What’s Going On?
Basically, the supply of muni bonds in the market
has increased substantially, while demand has fallen.
Some of that additional supply is due to increased
redemptions of tax-free bond mutual funds. Many
fund managers are being forced to sell some of their
muni bond holdings to pay for the redemptions.
Bond fund redemptions have increased for two
primary reasons:
1. Uncertainty and fear concerning the market volatility
and economic weakness
2. The general tendency of investors to prefer individual
bonds when bond rates spike, so they can lock in
those rates for a longer period of time
The table below shows that federal taxable-equiva-
lent yields — which are the rates a taxable bond must
offer in order to provide the same after-tax income
as tax-free bonds — are currently attractive.
Federal Taxable-equivalent Yields for a 5.5% Tax-free Bond*
Tax Bracket 25% 28%
Taxable-equivalent Yield 7.33% 7.63%
Source: Bloomberg
*Does not account for state tax considerations, which may increase your taxable-
equivalent yield further. Bonds may be subject to state, local or the alternative
minimum tax (AMT). Past performance is not an indication of future results.
Another driver of increased supply is due to selling
by hedge funds. The credit crunch has reduced the
availability of short-term loans that hedge funds use to
fund complex trading strategies. In addition, greater
volatility in muni bond prices is increasing the risk of
those strategies.
Demand is being driven down by institutional investors’
greater reluctance to buy tax-free muni bonds. The
increased price volatility in the muni market raises the
risk of owning bonds for institutional investors with a
short-term investment focus.
The combination of greater supply and lesser demand
means the market must reduce prices in order to
generate enough demand to exhaust supply. Lower
bond prices mean higher bond rates, which make
tax-free muni bonds more attractive today.
Opportunity Knocks
We believe this short-term supply-and-demand imbal-
ance currently provides an opportunity to lock in
attractive rates for tax-free muni bonds. These rates
have moved higher than some investment-grade quality
taxable bond rates.
We measure the relative value of tax-free muni bonds
by calculating the ratio between muni bond rates
and U.S. Treasury bond rates. Historically, this ratio
has averaged about 88%, meaning that rates of tax-free
municipal bonds were 88% of taxable Treasury
bond rates.
Today the ratio is at an all-time high of 145%, as
illustrated in the following chart. Although we can’t
predict how long this opportunity might persist, we
know that these imbalances have historically worked
themselves out with time. Subsequently, the muni
bond–Treasury bond ratio should revert toward
historical averages.
33% 35%
8.20% 8.46%
 MBD-4088H-A OCT 2008 Page 2 of 2
Ratio of Long-term Tax-free Municipal General Obligation Bond Rates to Long-term Taxable U.S. Treasury Bond Rates
150%

140%
Historical Average Ratio: 88% Current Ratio of 145%
130%

120%

110%

100%

90%

80%

70%
Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Feb Oct Jun Feb Oct
-80 -82 -84 -86 -88 -90 -92 -94 -96 -98 -00 -02 -04 -06 -06 -07 -08 -08

Source: Bloomberg
The long-term municipal general obligation bond rates are measured by Bond Buyer Municipal General Obligation Index. The long-term taxable U.S. Treasury bond rates are meas-
ured by Bond Buyer Municipal General Obligation Index. An index is not managed and is unavailable for direct investment. Past performance is not an indication of future results.

Diversification Opportunity markets. However, we don’t believe you should sell

Despite the recent increase in supply, you may find it
difficult to find muni bonds from your state from time
to time. If so, consider buying bonds from other states.
In some cases, the after-tax return of an out-of-state
bond may be similar to or even better than that of a
bond from your own state. In addition, it provides
geographic diversification for your bond portfolio.
your bonds unless you decide to rebalance or improve
the diversification or quality of your portfolio. If the
bonds are still appropriate and the reasons you origi-
nally purchased them are still relevant, we believe you
should stay the course. Although past performance is
not an indication of future results, bond prices tend to
rebound once market conditions begin to improve.

What should investors do?

Bond Price Declines
Periods of market volatility tend to present compelling
While the prices of numerous tax-free muni bonds have
buying opportunities. We believe that tax-free muni
declined over the past several weeks, we generally don’t
bonds represent a good opportunity. As a result, we
recommend selling them. Remember, bond prices
believe that, when appropriate, they can be a good
will rise and fall from the time you buy them until
addition to a well-diversified portfolio.
they mature or are called. However, interest payments
remain the same, and you should expect to receive the Mario De Rose, CFA
original principal amount back at the maturity or call Fixed Income Strategist
date, unless a bond defaults.
Diversification does not guarantee a profit or protect against loss.
The current turmoil has led many to question the safety
of their bonds. Clearly, significant challenges remain as
we attempt to navigate through the current stormy

Name www.edwardjones.com Member SIPC

Financial Advisor
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