Munis: Reading Beyond the Headlines

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Investors have long turned to municipal bonds for their tax-exempt status and security, but recent headlines have called this fixed-income asset class into question. This summer, Detroit became the latest city — not to mention the largest one — to file for Chapter 9 bankruptcy, potentially subjecting its bondholders to losses. Earlier this spring, in his budget proposal for fiscal year 2014, President Obama recommended capping tax-exempt interest from munis at 28 percent for the top 2 percent of earners.

 

Dan Heckman; photo by Alice Madden

Despite recent concerns, there is plenty of good news for municipal bond investors, says Dan Heckman, Senior Fixed Income Strategist for The Private Client Reserve. “Because of their tax-exempt status and current high yields, we believe municipal bonds still can be extremely attractive when placed in a balanced portfolio,” he says.

 

Here, Heckman addresses potential risks of municipal bonds and their tax and yield benefits.

 

DO YOU EXPECT MUNICIPAL BONDS TO RETAIN THEIR TAX BENEFITS IN THE FUTURE?

 

Despite proposals to cap the amount of tax-exempt interest an investor could earn, we are very optimistic that municipal bonds’ tax-exempt status will remain in place. There is strong opposition from issuers and municipalities, because they would have to issue bonds at higher yields to attract investors if they weren’t able to pass on the favored tax-exempt status. A coalition of city and county leaders, including the U.S. Conference of Mayors, recently estimated that interest costs would rise more than $18 billion for municipalities if a cap were placed on tax-exempt interest.

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We expect municipal bonds to continue to provide a huge tax advantage, particularly for those in the highest income tax brackets. In addition to earning interest that is exempt fromfederal income tax, depending on state of residency and where the municipal bond issuer is located, interest could be exempt from state income tax and perhaps even local income tax. Municipal bond interest also is one of the few areas where you are exempt from the 3.8 percent Medicare surtax on earned income over $200,000, or $250,000 for joint earners. (Income on municipal bonds is free from federal taxes but may be subject to the federal alternative minimum tax [AMT], state and local taxes.)

 

In fact, in January of this year, we began to see significant cash flows into the municipal bond market and tremendous demand for municipal bonds. We attribute much of the increase in demand to the higher marginal income tax rate and the introduction of the Medicare surtax.

 

AS AN INVESTMENT, CAN MUNICIPAL BONDS PROVIDE STABILITY?

 

The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.

So credit quality and default risk certainly are potential concerns.

 

But we believe situations like Detroit; Stockton, California; and San Bernardino, California — where large municipalities have filed for Chapter 9 bankruptcy — are the minority.

 

The market as a whole experiences extremely low default rates compared to other sectors of the bond market. A 2012 Moody’s report, “U.S. Municipal Bond Defaults and Recoveries, 1970-2011,” which compared default data for 54,486 individual issuers of muni bonds from 1970 to 2011, found that credit-rated munis defaulted only 71 times during that time span. On the other hand, of the 5,656 issuers of credit-rated corporate bonds, there were 1,784 defaults during the same timeframe.

 

Municipal bonds also may be a safe haven during certain volatile market conditions. As a fixed-income component of a balanced portfolio, they have a volatility dampening effect. In other words, when there is extreme volatility in equities, commodities or some other asset class, municipal bonds historically have not been tightly correlated. Of course, past performance is not a guarantee of future results.

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DO CURRENT MARKET CONDITIONS MAKE MUNICIPAL BONDS MORE ATTRACTIVE THAN TREASURIES?

 

As of June, 10-year munis provide yields of 2.20 percent; 10-year Treasury notes provide yields of 2.13 percent. It’s not normal for tax-exempt rates to be higher than taxable ones. But when you consider municipal bonds’ tax-exempt status, we believe muni bonds on a relative value basis can be extremely attractive compared with Treasuries.

 

However, it’s not just about yields. It’s also about where on the yield curve investors should look. It is our opinion that investors should consider municipal bonds primarily between five and eight years (as of June), when appropriate for their situation.

 

Keep in mind that as interest rates increase, bond prices typically decrease. This risk is usually greater for longer-term bonds.

 

WHAT ELSE SHOULD INVESTORS INTERESTED IN MUNICIPAL BONDS KEEP IN MIND?

 

Investors should understand that municipal bonds today are not like they were 30 years ago,  when you could buy a municipal bond in your local municipality, clip the coupon, and know you would get back your principal and interest.

 

Today, it’s a much more sophisticated market that takes a lot of time and effort for investors to understand and navigate.

 

There are broad divergences between economic conditions, both within states and on a state-by-state basis. Plus, the muni market doesn’t have the greatest transparency — two investors might pay totally different prices for the same municipal bond unless they know what they are doing. A July 2012 report from the U.S. Securities and Exchange Commission (SEC) found that pre-trade price transparency tends to be provided through electronic networks not broadly known by the public.

 

Investing in municipal bonds requires experience to know which credits and issuers to get involved in and which locations to avoid — some are obvious; some are not. The Private Client Reserve can provide that experience, which may work to the advantage of our clients.

For additional fixed-income analysis, see "Are You Diversified?"

 

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