There are different types of fixed-income investments, but municipal bonds offer a particular advantage — tax exemption.
In most cases, you don’t have to pay federal taxes on interest from muni bonds, as they are now, and generally they are also exempt from state and local taxes.
The higher your tax bracket, the more attractive these funds are to an investor, says Alan Schankel, a municipal bond strategist with Janney Montgomery Scott. And even investors in lower tax brackets can save plenty of money compared with taxable alternatives, such as Treasury bonds, he adds.
“Municipal bonds are a great source of tax-exempt income,” says Jon Mondillo, portfolio manager with Alpine Woods Capital Investors.
[See: The 9 Best Municipal Bond Funds for Tax-Free Income.]
For those with a typical investing portfolio of 60 percent equities and 40 percent bonds, Schankel says half of the fixed-income portion could be in municipal bonds and the other half in other types of fixed-income securities such as short-term Treasury bills, corporate bonds, agency mortgage-backed securities or Treasury inflation protected securities, also known as TIPS.
Of course, those in lower tax brackets need less exposure than investors in higher tax brackets, Schankel says.
For those investors in a high tax bracket, Jim Barnes, director of fixed income at Bryn Mawr Trust Co., says all of their fixed-income holdings can be in municipal bonds. Diversification would come by mixing in different types of municipal bonds, such as from different states or different types of revenue, he says.
“The municipal market in general is a high-quality market,” Shankel says, even though there have been some high profile cases such as Detroit and Puerto Rico casting a shadow over the space. But most “are very safe comfortable investments,” he says.
When do municipal bonds make sense? Municipal bonds, like other fixed income investments in the market, serve as a portfolio diversifier, but they also have advantages over corporate bonds beyond their tax-free status.
Mondillo says that although the municipal bond space has seen heightened volatility in recent months — which he predicts will continue through 2018 — historically munis have been less volatile than corporate bonds.
Within the bond space, an event that hurts corporate America, and thus corporate bonds, may not have the same impact on municipal America and the bonds associated with states and cities, Schankel says.
While munis serve to mitigate risk, not all are created equal, with some having more credit risk than others, depending on the issuer, Schankel says. However, riskier issuers, like Illinois, which currently lacks a state budget, will pay more, he notes.
Still, municipalities are less likely to default than corporations, he says, citing data from ratings agency Moody’s. And if it does come to bankruptcy, creditors may have stronger prospects for recovering money with bonds issued by municipalities than they would with those issued by corporations, Schankel says. (States can’t declare bankruptcy.)
For investors, another advantage over corporate bonds is that they start paying earlier, Schankel says.
What about rising interest rates? Because bond prices move inversely to their yield, as interest rates rise prices of munis, and most bonds, will drop.
“As interest rates rise, values of municipal bonds will fall,” Schankel says, adding that longer maturities will likely fall more than shorter-term bonds in the market.
Because longer maturities will be most exposed to changes in interest rates, Barnes recommends keeping the maturities of the munis an investor buys in the short- to intermediate-term.
That way, you’ll have bonds maturing at a faster rate, and you can reinvest your earnings in the higher-yielding bond funds, he says.
[Read: 4 Conservative Ways to Lock Away Wealth for the Future.]
Also, a strategy of buying bonds with higher coupons can do well when interest rates are going up, Barnes says. The more cash flow in the investment, the more someone has to reinvest in higher-yielding bonds, he says.
To position the Alpine High Yield Managed Duration Municipal Fund (ticker: AAHMX) for higher interest rates, its management has invested in bonds with durations of less than three years, Mondillo says.
Where to buy municipal bonds direct? Doing homework on the creditworthiness of an issuer is important when choosing which munis to buy, Barnes says. He recommends looking for issuers that are in good economies and have good reserve balances and fundamentals.
For people with smaller amounts to invest, Schankel recommends going the route of municipal bond exchange-traded funds, such as the iShares National Muni Bond ETF ( MUB).
But for those with more than $100,000 to put into the municipal bond market, he suggests hiring an advisor to help pick individual bonds.
Who are municipal bonds good for? For retail investors, he recommends sticking with good-quality munis rated A or better, such as those from Utah, South Carolina, New York, Massachusetts or California. For cities, he likes New York, San Francisco and Los Angeles.
To diversify beyond states and cities, Schankel also likes higher education bonds such as those issued by the University of Pennsylvania, Harvard and other Ivy League schools. For bonds, he prefers schools that are more selective and have diversified sources of revenue beyond student tuition.
Health care issuers can also make for solid municipal investments, he says, pointing to systems like the University of Pittsburgh Medical Center, Ascension Health Alliance and Mayo Clinic. The more geographic diversification, the better, he says.
He also likes revenue bonds such as those issued by the Pennsylvania Turnpike Commission or the Port Authority of New York and New Jersey.
Mondillo also points to transportation related bonds such as those issued to fund airports and toll roads, as the issuers stand to benefit if Washington goes ahead with talked about infrastructure spending.
[See: 10 Skills the Best Investors Have.]
He also likes the continuing care retirement space given the aging population of the nation.
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Tips for Investing in Municipal Bonds originally appeared on usnews.com
