What Has Less Risk, More Yield and No Taxes?

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Municipal bonds have been pummeled this year. First, all bonds have become toxic, as their historically low rates, coupled with fears of the Federal Reserve tapering off its bond buying, have investors fleeing.

Second, Detroit, owing $18 billion, has gone bankrupt: City leaders have questioned repaying its bond debt before its pension obligations. This weakened a fundamental tenet of muni finance, that issuers’ first priority is their debt.

Finally, a rip roaring bull is coaxing retail investors back into equities. Munis, despite their tax advantages, are no match for surging stocks.

Nevertheless, municipals remain free from Federal taxes, and state taxes, too, if issued in an investor’s home state. Proposals to change this tax free status don’t seem imminent, and may well grandfather any bonds already owned.

In a Nutshell

Due to a perfect storm of macro events, municipal bonds have become cheap, perhaps not relative to a decade ago, but cheap relative to alternatives and recent history. For safety conscious investors, municipals have a stellar track record, yet yield more than other bonds with the same credit ratings. Finally, despite taxes continuing to rise, municipals maintain their tax free status, enjoying immunity from state and local taxes if issued within an investor’s home state.

Bottom line, yields significantly outstrip similarly rated corporate debt, yet the income remains free from taxes; taxable investors are well advised to stock up now.

Why Bonds at All?

Municipals are cheap because investors don’t like bonds. Amid the Fed’s threats to taper, an improving economy, reviving stocks, and pundits warning of higher rates, Why Bonds? is a good question.

Investors can’t forsake bonds. The anti-bond fears may not materialize; pro-bond scenarios could develop. The Fed could defer tapering to combat economic weakness. War, perhaps in Syria, could brake growth, driving bond demand. A good old fashioned bear in stocks could stoke fixed income demand.

If you do dump bonds, where do you go? In 2008, high quality bonds were one of the few assets offsetting stocks’ 37% plunge; moving your bond money to stocks strips you of that defense. Cash is an option, but with no yield despite continuing inflation, that’s not a long term strategy; who’s going to tell you when to flip out into something better?

Some tout alternatives/hedge funds as a bond substitute. However, most alternatives did not perform a desired function of bonds, offsetting stocks’ declines, during the last downturn, in 2008. With the average hedge fund down 16%, most alternatives failed to provide an offset to stocks. However, the broad Barclays Aggregate, the principal bond index, advanced 5.2% in 2008, mitigating stocks’ losses.

Finally, with rates up 1% or more over this time last year, yields are improved.

In sum, bonds are a form of insurance. Just as you wouldn’t forsake car insurance if premiums got pricey, you can’t turn your back on fixed income.

Great Relative Value

Historically, municipals yielded less, just 85% of similarly dated Treasuries, because the income was tax free. Today, however, the ten year stands at 2.75% versus similar munis’ 3.4%.

Munis now yield about the same as corporates, 3.4%; historically, munis yielded 25% less. But, with high net worth investors having to pay up to half that corporate interest for taxes, the choice seems easy. Remember, too, that municipals have a far better credit history than corporates.

Still not convinced that munis offer better value for the same risk? There are some corporations that are the primary backer of municipals, where a public entity has issued tax exempt bonds on its behalf for a particular project. Yet, despite the interest being tax exempt, the yield is greater than the same corporation’s fully taxable bonds! For example, International Paper’s tax exempt bonds maturing in 2019 recently yielded 4.5%, while its similarly rated conventional corporate bonds yielded 3.23%.

The Detroit Risk

Detroit’s problems are unique: Decades of mismanagement, coupled with continued erosion in the health of the auto industry and a rapidly declining population, pushed it over the brink. It’s not representative of America. Indeed, most state and local jurisdictions are seeing an uptick in tax revenues and property values as the recent recession fades.

Further, the argument that the claims of pensioners trump secured creditors is unlikely to prevail nationwide. Borrowing costs would surge, while the public is skeptical of public pensions that trump what’s generally available in the private sector.

Unfortunately, we would also not rule out a Detroit bailout. Bailouts happen. The implications for all borrowing nationwide might be severe if Detroit’s bondholders are stiffed. Politicians could successfully argue that it would be cheaper to make Detroit’s creditors whole than for states and municipalities to pay higher rates due to its default.

In sum, Detroit should not cause you to abandon munis.

Buy a Muni Basket

While we don’t think Detroit is representative of most issuers, there are other troubled debtors out there. A ruling in Detroit adverse to bondholders may put pressure on similar bonds elsewhere.

Diversification is the answer. While Detroit may or may not be too big to fail, there’s no dispute that the muni market en masse is too big to fail. Take advantage by simply buying a muni mutual or exchange traded fund containing many different bonds.

Select a fund with longer maturities to garner more income, but only if you are willing to take on greater risk should rates rise. Accept greater credit risk for higher yields, but your fund may have greater exposure to weak jurisdictions like Detroit, and sag if economic conditions deteriorate.

We favor Fidelity’s Spartan Tax Free Bond (FTABX, Financial), yielding 3.3%, and the exchange traded iShares National AMT Free Muni Bond (MUB, Financial), with a 3% yield.

Get it Guaranteed

Many municipals are guaranteed by an insurance company. This eases decision making; instead of having to research the typically murky financial statements of a municipality, you can simply rely upon the credit strength of the insurance company guarantor.

Unfortunately, insurance companies don’t have the credit strength they used to, pre-mortgage crisis. Further, you don’t want too much exposure to any one insurer and there aren’t too many of them. On the other hand, you have as a backstop to the insurer the underlying municipality.

Many investors shy away from a tough credit despite the insurance. A Detroit bond, maturing in nine years, is fully insured by AGC so is rated AA- by S&P. But, it yields 5.3%. For a high bracket tax payer that’s the same as a 9.4% pre-tax yield. You won’t find a 9.4 pre-tax yield with that credit rating.

Stick With GOs and Essential Services

Despite the legal issues posed by Detroit’s bankruptcy, a general obligation (GO) bond of a thriving large state or municipality is a good bet. GOs are backed by the full taxing authority of the particular jurisdiction.

It remains inconceivable that a state would default on its debt. While other states may not want to help, that fact is that any state is too big to fail because it would threaten others’ ability to raise money. It would be cheaper to help that state than to have many states effectively shut out of the debt markets at any reasonable interest rates.

Bonds backed by essential services, like sewer and water, are seen as safe, too. Steer clear of bonds issued for less important facilities, like stadiums, absent thorough analysis.

Don’t Overdo the Home State

While the interest on bonds issued in your home state is typically free from state taxes, be mindful of not letting the quest for tax avoidance breach diversification principles. Having all your bonds in one state’s basket may not be worth the taxes saved if there’s a downturn or natural disaster in your region.

The interest on bonds of some jurisdictions, like Puerto Rico, the Virgin Islands, and Guam, is exempt from all states’ taxes, so are worth considering to diversify home state exposure yet still avoid home state taxes.

Closed End Funds: Good Portfolios Marked Down

Closed end funds (CEFs), essentially mutual funds that trade all day on the stock exchanges, can be profitable vehicles to invest in municipal bonds. They are like exchange traded funds, but there’s no mechanism to keep their shares trading in line with the net asset value (NAV) of their holdings. Look for muni CEFs trading at a material discount to their NAVs.

Municipal CEFs are typically leveraged. By borrowing short term at low rates, they can purchase more municipals paying higher rates, and their investors pocket the extra yield.

The Putnam Managed Muni Income (PMM, Financial) trades at an 8% discount to NAV, has borrowed funds equal to 23% of its portfolio, and sports a payout of 7.1%.

Some state specific funds sport even greater discounts, often a function of investor perception of that state. Nuveen Michigan Quality Income Muni (NUM, Financial) has a similar yield (7.1%) but a bigger discount (10.1%), with greater profit potential if the discount narrows. Undoubtedly, Detroit’s travails color perceptions of this fund, but experts do not see Michigan or its entities generally defaulting.

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