Harvard economist Jeffrey Frankel makes an interesting point about an always sexy topic—municipal bonds!

“One U.S. asset class strikes me as undervalued relative to the rest: municipal bonds. AAA-rated munis of each maturity pay a higher yield than Treasuries of the same maturity. The differential is as high as 50 basis points for the 2-year and 30-year maturities. Yet state and local bonds are tax-exempt while treasuries and corporate bonds are not. (I am only recommending munis for the taxable part of the portfolio of a taxed investor, of course. Put equities in the tax-exempt part.)

“The obvious reason why state and local governments might have to pay more to attract investors is risk of default. But it is likely that investors fear default on munis more widely than they should. Default is rare, notwithstanding the long memories left by financial troubles in New York City and Orange County in decades past. (Furthermore, when there is a default, holders of munis usually enjoy a higher recovery rate than holders of corporate bonds.)”

On the taxation of “munis,” American Enterprise Institute resident scholar Alan D. Viard has highlighted their tax status in the context of an important Supreme Court case “in which the taxpayer-plaintiffs contend that Kentucky violates the dormant commerce clause (DCC) of the U.S. Constitution by granting its residents a state income tax exemption for interest on home-state municipal bonds while taxing out-of-state municipal bonds. This selective exemption for home-state municipal bonds, also practiced in some form by 42 other states, is a significant barrier to interstate commerce and has balkanized the municipal bond market. The Supreme Court should affirm the Kentucky Court of Appeals’ ruling and strike down the exemption under the DCC.”