Municipal Bonds

Did you know that states, counties, or municipalities also can issue bonds? These bonds are called “municipal bonds”. As they are issued by local governments, they are mainly used to finance infrastructure projects such as the construction of highways, bridges or schools.

What is special about the municipal bonds is that they are exempt from federal taxes and most state and local taxes. Nice, huh? So although their nominal yields are generally lower than corporate bonds (but higher than the federal Treasuries), the municipal bonds offer higher after-tax yields than corporate bonds with the same coupon rates. It makes them especially attractive to people in high income tax brackets who need relatively safe (but not without risk, as the case of Detroit’s bankruptcy clearly shows) and a tax-free revenue stream. They are a sought after investment choice in anybody’s investment or retirement portfolio, as they allow the investor to stay in a lower tax bracket. In a way, this is similar to the risk aversion and diversification benefits gold in one’s portfolio brings.

Municipal Bonds and Gold

What is the link between municipal bond yields and the gold prices? Well, it should be similar to the relationship between the bond yields and gold prices. Generally, we should expect negative correlation between these two series (and the positive correlation between gold prices and bond prices). This is because when the bond yields decline, gold looks more attractive. When yields on other assets drop, the opportunity costs of holding gold, which does not bear any yield, also go down. The same logic should apply to municipal bonds. Or, the link could be even stronger, as both assets should be more attractive during periods of financial stress such as zero interest rates or negative interest rates.

But what do we see in data? As you can see in the chart, there is indeed a negative correlation between the gold prices and the municipal bond yields (represented by Bond Buyer Go 20-Bond Municipal Bond Index, which tracked the average yields of 20 general obligation municipal bonds; now the series is unfortunately discontinued). The correlation is -0.41, so not very high, but still substantial.

^{Chart 1: Gold prices (yellow line, left scale, London P.M. Fix, in $) and the municipal bond yields (red line, right axis, Bond Buyer Go 20-Bond Municipal Bond Index, in %) from January 1971 to September 2016.}