My Opinion: Tax-exempt municipal bonds are attractive right now

Since late last year, I’ve had several clients ask about the viability of municipal bonds. In December 2010, the CBS program, 60 Minutes, had a segment on munis, the gist of which was that many municipalities were in financial trouble. The story featured an analyst who predicted that hundreds of billions of dollars in muni bonds could default.

Larry Bakerjian, CFP®, LB Asset Strategies

That 60 Minutes show created quite a fuss in the muni bond market and, coupled with the fact that many states have on-going budget issues, have called muni bonds into question.

Before going on, let’s briefly discuss just what municipal bonds are. Any bond, including a muni, is an I.O.U. The difference between munis and other bonds is that you are lending money to a municipality — a city, state or other governmental entity — to finance the building of schools, roads and other public works.

According to Securities and Exchange Commission, munis also include general obligation bonds, which are backed by the “full faith and credit” of the issuer, and revenue bonds, which are backed by revenues from a specific project. Some municipal borrowers even issue bonds on behalf of private entities — colleges and hospitals are examples of these — who agree to repay the issuer who in turn pays the interest and principal due on the bond. In some cases, muni bond revenues are used to fund day-to-day municipal obligations.

So, munis represent a broad category of investments.

The advantage munis have over other bonds lies in their tax benefits: The interest paid on muni bonds is often exempt from federal taxes, which of course makes them attractive. Further, many states, California included, allow their residents to exclude interest from state tax when the interest comes from a bond issued in their home state.

It’s easy to see why investors had a sense of unease about these bonds late in 2010 and well into this year. In fact, many investors sold their muni bond holdings during this time. The Wall Street Journal, for example, reported on November 26, 2010 that investors had “pulled an estimated $4.78 billion out of municipal-bond mutual funds” in just one week of that month — $4.78 billion. For a long-term investor, I think that was a big mistake.

Fortunately, virtually none of my clients took the approach of selling their munis and now, in September 2011, they’re benefiting from holding such bonds. In fact, when the stock market fell in August, guess what one of the strongest performing asset classes was? Yep, muni bonds.

As in all investing, it’s important to cut through the hype and to try and understand what’s really happening. That’s not easy, but if you can do it you’ll often save yourself from making mistakes. After that episode of 60 Minutes aired, it was easy to buy into the fear that muni bonds were going to fall like stones and that the sooner you got out of them, the better.

But if you could step back from the hype, you’d see that historically, muni bonds have a very strong track record of doing what they say they’re going to do, namely pay interest when it’s due and return principal when the bond matures.

Municipal bonds have a good track record. While nobody can perfectly predict the outcome of the bond markets, you can at least take comfort in knowing that municipal bonds have had a good history of performance:

  • Munis have a long history of low default risk. For example, Moody’s Investors Service-rated municipal issuers have a very limited default experience. Among more than 18,400 munis rated by Moody’s during the 40 years from 1970 to 2009—a period that includes 5 recessions—only 54 issuers defaulted. That’s .3%, less than one third of one percent.
  • Muni yields right now are good. According to a Wall Street Journal article, “Who’s Afraid of Munis?” which ran April 4, 2011, said “some attractive municipals have tax-exempt yields that, for a high-income taxpayer, would be equivalent to around 5% on a taxable bond. Where else might you find 5% taxable yield on an investment with low risk?

It’s true that municipal bonds are subject to risk. They are especially tied to changing interest rates, the credit markets and inflation. Another risk associated with munis can be a lack of liquidity, which means that it may not always be easy to find buyers.

Have you reviewed your investment plan lately? Speaking broadly, I believe municipal bonds can play an important role in many of my clients’ portfolios. There are no guarantees on market performance, and everyone’s situation is different. A good investment plan that matches your personal circumstances can go a long way to meeting your needs and goals.

View any concerns that you read and hear over the current municipal bond market as an opportunity to have a conversation with me about this. Then, go break a sweat the old-fashioned way. Hop on a treadmill at your gym. Ride a bicycle. Walk on the beach. My preference is go and whack a racquetball. Whatever you do will help deflect the hype and improve your perspective.

Note: I encourage investors to weigh several factors before they invest in municipal bonds. They should take into account the overall economic health of the region or customer base and the impact it might have on the revenues the entity depends upon in order for it to sustain its bond payment commitments. Understand the exact source of the revenues that will service and repay the debt. Consider the entity’s track record of operational effectiveness. Assess the competence of financial management of the entity. Has its credit rating been maintained or strengthened over a period of time. Read the issue’s Official Statement, this document will provide the information covered above.

Investments in Municipal Bonds may subject the investor to the Alternative Minimum Tax (AMT). Any fixed income security sold prior to maturity may be subject to a substantial and taxable gain or loss.

This article material is for general informational purposes only and should not be considered a recommendation to buy or sell any security, nor a specific investment strategy. I do not provide tax or legal advice. Readers should consult their tax advisor, or legal counsel, for advice concerning their particular situation.