When investors looking for fixed income weigh their options, bonds often rise to the top of the list.
These securities allow you to act as a lender of sorts, pooling with other investors to provide capital to corporations or even the U.S. government in exchange for fixed interest payments. Bonds are very attractive because they offer a guaranteed annual return, and much lower risk than investments in stocks or mutual funds.
But one corner of the bond universe that is sometimes misunderstood and often overlooked is the municipal bond market.
These securities are created when a state, county or city government embarks on a project like a new road or school, and looks for investors to help finance the project.
Municipal bonds are similar to corporate bonds or U.S. Treasury bonds in this way, since they are ways to raise capital for big spending plans. But there are some important differences that make “muni” bonds a very powerful tool for investors looking for income.
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One big appeal is how municipal bond income is taxed. “Corporate bonds are generally fully taxable as ordinary income, meaning you’re paying you marginal tax rate on the coupon payments,” says Charles Sizemore, chief investment officer at Sizemore Capital Management.
By contrast, “muni bonds are not taxable at the federal level” and many are also issued with exemptions from state and local taxes, Sizemore says. That means you keep more of your income, instead of seeing it whittled down by the tax man.
Another big appeal is that muni bonds historically have been a safer bet than debt issued by corporations. Default rates are much lower for municipal bonds when compared with corporate bonds with a similar credit rating, David Dowden, the portfolio manager of the MainStay Tax Free Bond Fund (ticker: MTBAX) and senior managing director at asset manager MacKay Shields.
“Both Moody’s and Standard and Poor’s put out default studies on the municipal bond markets,” Dowden says. “And when you look at BBB rated municipal bonds — that is, the lowest investment-grade rating category before junk bonds — it’s actually lower than the default rates on AAA corporates.”
That’s in large part because, unlike corporations, municipalities that issue bonds have an easy way to raise money if they fall behind on their payments — simply raise taxes.
“I would consider muni bonds to be safer than most other fixed income alternatives out there,” Sizemore says. “Even though a local government’s taxing power is not unlimited, they can usually raise taxes or cut government services to make their payments.”
Also, municipal bonds are less correlated to other asset classes — including the broader bond market. That makes them a crucial tool in a diversified portfolio.
The unique nature of municipal bonds even insulates them in part from a rising interest rate environment that can depress values for corporate or Treasury bonds, Dowden says.
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“If rates are rising because of stronger economic activity, the net result is that revenues coming into these municipal issuers is going up as well and fundamentally, they’re strengthening,” he says. “There are periods of times when muni bonds actually have a negative correlation to what’s going on with 10-year Treasurys.”
Particularly in the current environment where interest rates appear to be moving higher and the Federal Reserve is looking to tighten policy, municipal bonds may be a particularly good bet for income investors.
However, while municipal bonds hold promise, they can still be confusing for individual investors. That’s why your best bet may be to invest in these income instruments via a diversified fund or via a qualified asset manager.
After shocks to the credit market over the last decade resulted in serious trouble and after the steady decline of bond insurance to guarantee payouts, there are very real risks for those investors who try and go it alone. And on the other side, the misunderstood nature of the municipal bond market also allows an effective fund manager to deliver sizeable returns that more than justify their fees.
“With everything going on in the market, the average investor doesn’t have access to the information they need to make good decisions the muni market,” Dowden says. “And I strongly believe that because the municipal bond market is so inefficient when compared with the equity market, there’s tremendous opportunity [for professional managers] to add value to clients.”
Beyond hiring a manager directly or investing in municipal bond mutual funds, Sizemore cites the opportunity to buy municipal bonds in closed-end funds — vehicles that resemble mutual funds, but have raised a fixed amount of capital and then trade up or down based on market sentiment.
If you’re savvy, he says an investor can find a closed-end muni bond fund that is actually trading for significantly less than its underlying municipal bonds are worth.
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“When buying closed-end muni funds, never pay full price,” Sizemore says. “Wait for them to trade at a 5 percent to 10 percent discount to net asset value. Doing so is no guarantee of returns, but it certainly gives you a better margin of safety.”
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Why You Should Consider Municipal Bonds originally appeared on usnews.com
