In early 2002, 30-year Treasury bonds were yielding 5.36 percent while 30-year AAA-rated municipal bonds were yielding 5.15 percent, a 96 percent ratio. Thus, all taxpayers, in any bracket, would be better off in long-term munis than in long-term Treasuries.
For shorter maturities, the muni-Treasury yield gap was wider but still narrow enough to appeal to many investors. At 10 years, munis (4.44 percent) paid 90 percent as much as Treasuries (4.89 percent); for five-year maturities, muni yields (3.46 percent) were 83 percent of Treasury yields (4.16 percent). Especially if you’re in a high tax bracket, munis make sense. Why buy a five-year Treasury, where the after tax yield would be barely 2.5 percent, when you can earn nearly 3.5 percent in a top-rated tax-exempt bond of the same maturity?
However, while munis currently have an edge over Treasuries, the comparison with corporate bonds and mortgage-backed securities is not as clear-cut. For example, in January Morningstar reported that Vanguard’s Short-Term Corporate Bond Fund was yielding 6.3 percent while the company’s Short-Term Tax-Exempt Fund was yielding 3.9 percent, for a 62 percent ratio. Thus, if the choice is between those two funds, only those with effective marginal tax rates over 38 percent would be suitable for the tax-exempt fund.