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Beauty of muni bonds is tax-free income. Here are three key takeaways for investors
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After years of TINA, or the “there is no alternative” to stocks, bonds are once again in the spotlight. The selloff in bonds this year has pushed prices down and yields up, making municipal bonds an attractive place to seek income, especially for high-income investors in states with the high marginal tax rates. But there is more to the asset class than the tax-free benefits. Municipal bonds, or munis, have outperformed other bonds this year, but have still slumped. The Bloomberg U.S. Aggregate Total Return Index, a basket of different types of bonds, is down more than 15% year to date, while the Bloomberg municipal bond index has shed about 12%. Because yields move inversely to price, this means yields are at the highest in more than a decade. “The significant selloff has created opportunities that we largely haven’t seen in 15 years,” said Cooper Howard, fixed income strategist for the Schwab Center for Financial Research. “To be candid, this is an exciting time in bonds,” said Megan Gorman, founder and managing partner of Chequers Financial Management in San Francisco. 1. Consider tax-equivalent yield Munis are tax-exempt at the federal level and at the local and state level for residents of the issuing state. This means that a taxable bond would need to earn a higher yield – and potentially face greater risk – to match the return on the municipal bond. For example, individuals who are subject to the top federal tax rate of 37% can get similar tax equivalent yield from a 5% muni bond and an 8% high-yield corporate bond. Given that a corporate bond with a yield that high is usually junk-rated, the muni is a much safer bet for the same income. But that doesn’t mean that investors should only buy munis from their home state to reap double or triple tax-exempt income. Investors in states that have high taxes and issue lots of munis, such as California and New York, may be able to focus on in-state bonds and benefit from multiple levels of tax benefits. But investors outside of those states may struggle to only invest in-state and still maintain a diversified bond portfolio, according to Howard. “We suggest that if you’re investing in municipal bonds, individual bonds, you invest in 10 different issues with different credit risks,” he said. “That could be relatively difficult in one state.” That means that most portfolios should include a mix of munis from states beyond an investor’s home residence. A balance of 75% to 80% of munis from in-state and the remainder from out-of-state generally works, said Scott Sprauer of MacKay Municipal Managers. In addition, though investing in-state means no taxes, you may get higher yields or at least an equivalent yield by snapping up an out-of-state muni. That’s because of tax-equivalent yield, which is the yield that a muni or other bond gives after taxes are paid. 2. Credit ratings still matter While yields on munis have jumped, it’s also vital for investors to look at each bond’s credit rating and not simply chase the highest income. As with other bonds, those with lower credit ratings carry more risk that the issuer will default. “Getting your money back is” key, said John Luke Tyner, fixed income portfolio manager at Aptus Capital Advisors in Fairhope, Alabama. It’s also a good idea to consider what the bonds are being issued for, as some projects are safer than others. For example, schools are generally a safe bet as they’re tax supported. Hospitals and utilities like water and sewers are essential and so are also likely safer muni investments than sports stadiums or highways. Other types of munis to closely scrutinize are publicly-backed private projects, such as the American Dream mall in New Jersey or the Brightline Rail project in Florida, which carry higher risk. But, generally speaking, credit quality in the municipal bond market has been strong during this latest cycle. “Part of the reason why is the amount of fiscal aid that was provided to state and local governments right after the coronavirus crisis began,” said Howard. “That was substantial.” Of course, when comparing munis to corporate bonds, there is one important distinction — typically corporate debt is unsecured, meaning that it has no collateral backing. By contrast, munis are generally secured with local and state incomes, sales and property tax receipts, making them safer. This is also important going into a recession, when some corporates are more likely to get swiftly downgraded, said Sprauer. “That’s less so in the muni marketplace because it’s very, very stable,” he said. 3. Investing differs from stocks Muni bonds serve a different goal in a portfolio than assets such as stocks, which you hope go up in value over time. For bonds, and particularly munis, investors aren’t looking for returns so much as they are looking for income, and if the issuer will make payments on time. “There’s typically some price appreciation with it but it’s hard to bank on price appreciation unless you’re a very active muni bond trader,” said Tyner. For retirees, this piece of the puzzle is especially beneficial as they want portfolios that yield income, especially in a year when stocks have shed value. “If we look at the traditional retirement planning strategy, you want to have things like Social Security, pensions, dividend income and you also want a layer of bond interest,” said Gorman. “And if it’s tax-exempt bonds interest, that’s even better.” Because municipal bonds are so complicated and there are nuances in every investor’s portfolio, experts generally recommend leaning to a bond fund manager or working with a financial advisor or another expert to determine what to buy. Diversified muni bond mutual funds are also a good option for investors, giving access to the muni market without having to take on the risk of buying individual bonds. See below for a list of muni bond funds:
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