Where to find good opportunities in munis
Municipal bonds are not the bargain they were two years ago, but there's still good value to be had, especially compared to U.S. Treasuries. Some do's and don'ts.
Taxes for high earners look likely to rise next year, but those who feel the urge to park money in tax-free municipal bonds should shop carefully.
Plenty of investors have had the same thought since Election Day. A popular exchange-traded fund of these bonds, iShares S&P AMT-Free Muni Bond, has gained 1.5% since then, and 5.2% year-to-date. That might sound like small potatoes, but as bond prices rise, yields fall, and a muni universe that was recently an obvious bargain is now an iffy one.
Compared with Treasury bonds, munis still look cheap—but so does nearly everything else that carries a rate of return. Triple-A general-obligation munis, backed by the taxing authority of the issuer, yield 1.74% at 10-year maturities, a bit more than the 10-year Treasury's 1.62%. Historically, muni yields have tended to be only 85% to 90% of Treasuries', with investors making up the difference in tax breaks, says Dan Heckman, a fixed-income strategist at U.S. Bank Wealth Management.
Demand for munis is dominated by retail investors who are easily scared off and slow to return. Indeed, yields got so juicy two years ago, after a prominent analyst warned of widespread defaults, that even investment funds focused on providing taxable income with corporate bonds were dipping into munis. The default crisis didn't materialize, and now munis have retuned to pre-scare levels.
The muni discount versus corporate bonds is gone, says Chun Wang, a portfolio manager at Leuthold Weeden Capital Management. Since 1979, munis have yielded a median of 1.15 times as much as corporates, once their yields are adjusted to taxable-bond equivalents based on 35% tax rates, according to Wang. As recently as the end of October the ratio was 1.25. Now, it's 1.10.
However, investors who have put off their muni shopping until now can still find good deals using a targeted approach. Here are some dos and don'ts:
Don't just create an evenly laddered muni portfolio, with bonds coming due every few years. Yields on the short issues are well below the rate of inflation, which will erode wealth over time. Instead, favor intermediate maturities where yields take relatively sharp jumps.
For example, many buyers ask their brokers for 10-year bonds; it's a nice round number. That creates a minor demand bubble there, says Matt Fabian, managing director of Municipal Market Advisors, a Concord, Mass., research service. Recently, 12-year, AAA-rated bonds yielded 2.20%, versus 1.48% for nine-year ones. Investors who buy the 12-year paper get the higher yields, plus an added benefit: As the bonds age three years, they may rise in price, so that their yields match those for nine-year issues. This "roll-down" effect works only if rates stay where they are.
Do delve into bonds rated a couple of notches below perfection. Defaults by municipalities are rare, relative to those by corporations, and the percentage of funds recovered by investors in the case of default is typically much higher. Look to A-rated bonds for good value from a risk/reward perspective, says Peter Hayes, head of the muni group at BlackRock. From 1970 through 2011, the default rate for these munis was just 0.04% over 10-year periods, versus 2.22% for comparably-rated corporate bonds, according to Moody's.
Don't buy all home-state bonds. A New Yorker who buys his state's bonds gets the federal tax break offered by most munis, plus a break on state taxes (and maybe even local ones if he lives and buys in New York City). But bonds from outside states bring the benefit of diversification.
New Yorkers can put 70% or more in home-state bonds because of high taxes, decent state finances and a deep universe of local bond issuers to diversify among. California has weaker finances, but coastal cities are doing better than inland ones, and state taxes are headed to shockingly high levels, up to 13.3%. Buyers there should also favor in-state munis. Rhode Island and Connecticut, on the other hand, have weak economies and limited muni supply, so residents should limit their in-state buying to 40% or 50% of their portfolios.
Do shop for out-of-state bonds from states that don't have income taxes, like Texas, Florida, Nevada and Washington. They lack strong local demand, leaving yields a touch plumper.
Do keep fees low, but don't assume index mutual funds offer the best deals. The bonds they track tend to stay in high demand, while active fund managers can look for higher yields among less-popular issues. Fidelity Tax-Free Bond
Do seek help selecting individual bonds. Thanks to falling rates and a dearth of new issues, many bonds can be called away before maturity at lower prices than they currently sell for, which can trip up the uninitiated.
Above all, don't buy munis in hopes of scoring short-term gains when taxes rise. That's already priced in. Probably the only thing that will drive a big muni rally from here is if Congress trims the tax break on muni interest, while grandfathering in existing bonds. Barring that, buyers should expect to get their bond interest and not much more.
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