Municipal bonds were once considered the gold standard of investment options thanks to their tax-exempt status. Income from these bonds is tax-free at the federal level and usually exempt from state taxes in the bond issuer’s state. Since the financial crisis, though, the market has changed, with more “munis” now concentrated in the hands of institutional and wealthy investors, and more public projects funded privately.
As a result, fewer municipal bonds are in circulation or being issued. A report from the Hutchins Center on Fiscal and Monetary Policy at Brookings Institution found that new bond issues — not those being restructured or refinanced — dropped 25 percent between 2005 and 2016, which is a much faster rate than the decline in state and local capital spending during that time.
“State and local governments are in a holding pattern when it comes to raising additional money for new projects,” says Jason Ware, managing director and head of institutional trading for 280 CapMarkets in San Francisco. “A lot of it [is because] we haven’t come up with an infrastructure plan for the country yet.”
[See: 7 Basic Materials Investments to Buy in 2017.]
In fact, many municipalities have called their loans and re-financed most of the bonds they’ve issued in the past, much like an individual would refinance a mortgage to lower interest rates. “Essentially, they’ve taken them off their balance sheets, and all those bonds have been called out of the market or turned into extremely short-term loans,” Ware says.
All of this has implications for individual investors, whether they own municipal bonds directly or indirectly through mutual and exchange-traded funds, which is increasingly the case.
Investors flock to bond funds. Between 2005 and 2016, household ownership of municipal bonds fell from 53 to 44 percent, according to the Hutchins Center, while depository institutions’ stake in the game rose from 5 percent to nearly 15 percent during that period.
Most individuals invest in municipal bonds through exchange-traded funds and mutual funds, Ware says, which is why you see such concentration in the hands of institutions. “A lot of that is retail money,” he says. “Investors are just buying bonds through those vehicles to get their exposure.”
That can create problems investors don’t know about. For one thing, investors might not realize a single state municipal bond fund also may own territory debt from Puerto Rico, Guam or the Virgin Islands, says Beth Foos a senior analyst at Morningstar Research Services in Chicago.
More important, the rules of the game change when you own bonds through a fund. “In a rising interest rate environment, the individual bond can protect your principal because your bond has a final maturity date with a hard stop,” Ware says.
When you hold municipal bonds through a mutual fund, however, you’re beholden to market fluctuations and how the fund you’ve invested in is trading, Ware says. If interest rates go up, the bond fund will decline in value and investors may not be able to recover their principal, Ware says.
[See: The 9 Best Municipal Bond Funds for Tax-Free Income.]
That’s also why investors should avoid purchasing a municipal bond within an IRA, says Billy Funderburk, president of Funderburk Financial in Longmont, Colorado. In addition, investors who hold muni bonds in a traditional IRA won’t receive the tax-free benefits because IRA withdrawals are taxed as ordinary income. Although withdrawals aren’t taxed in a Roth IRA, there are better-paying bonds than municipals to invest in. For instance, investors can secure a higher interest rate through a corporate bond, which typically nets a return that is 1 to 2 percent higher than a municipal bond will bring, Funderburk says.
A lack of transparency discourages direct investment. Investors flocked to funds and ETFs in part because bonds are a hassle to buy and trade directly on your own. When municipal bonds are purchased directly, the published list price isn’t always the bond’s final price. “A bond trader can offer any bond he wants at any price he chooses,” says Bob Williams, a senior vice president and managing director for Simmons First Investment Group in Little Rock, Arkansas. “But that doesn’t necessarily mean it’s a fair price.”
Like going to a car dealership, specialty bond traders can haggle behind the scenes for cheaper, non-list prices. That makes it easy for unsophisticated municipal bond investors to overpay or sell a bond too cheaply, Ware says. “The municipal marketplace is fraught with risk even for the most knowledgeable traders,” Williams says. “It’s tough for novices.”
Ordinary investors can’t get their hands on accurate, timely information about the bonds, a problem that is more prevalent with municipals than for other fixed-income products. Investors can check recent trade prices of bonds on the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access, but “the markets aren’t as transparent or real time as the stock market,” says Mark J. Alaimo, managing director for wealth management at Sapers & Wallack in Newton, Massachusetts. Meanwhile, annual financial reports from the municipality are often published three to eight months after their calendar year, and how much information they provide varies greatly based on a municipality’s budget and local political pressures, Foos says.
Still, holding the bonds directly, especially with the help of a professional advisor who understands the market, is how most experts say you should invest in municipal bonds. That way you retain the benefit of protected principal. Despite Puerto Rico’s request to restructure more than 70 billion in debt, most municipal bonds have a low default rate, Ware says.
Williams suggests investors consider purchasing bonds issued in their home state, city or country so they can stay informed about any local news that could affect the credit quality of the municipality and the bond. Consider how likely the issuer is to pay back on the schedule promised, which is often reflected in the credit rating, Foos says. Look for states with diverse economies, revenue streams and well-funded pensions, Ware says, because poor credit ratings at the state level can trickle down to affect local credit ratings. Wisconsin, North Carolina and South Dakota have some of the best funded pensions with Illinois, Kentucky and Connecticut the least funded.
You’re better off holding the bond until maturity. With fewer direct buyers of municipal bonds, investors who don’t hold the bonds till maturity could have a hard time selling them. In most cases, municipal bonds offer lower yields than taxable fixed-income securities, wider trading margins and more exaggerated price swings, Ware says. That’s made the market of more than 1.5 million individually held municipal bonds generally less liquid than other fixed-income products such as Treasurys and high-grade corporate bonds, Ware says.
Many financial experts also say lower tax rates, which the Trump administration wants, could make tax-exempt municipal bonds less attractive for high-net-worth investors, who won’t have as much incentive to invest in the bonds to reduce their tax bill.
[See: 9 Ways to Invest in America With Bond Funds.]
That’s why it’s generally best to keep bond investments, municipal bonds included, to a shorter duration of three years or less right now, so you’re not locked in at a 3 percent rate for 30 years, Alaimo says.
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Navigating a Changed Municipal Bond Market originally appeared on usnews.com
