Death and taxes are often said to be certainties of life. But there is a corner of the financial markets where you may be able to avoid at least one.
In general, interest paid on municipal bonds is not taxed at the federal level, or by the state or city that issues them as long as the buyer also lives there. And these bonds also offer diversification and a measure of safety to portfolios.
In June, despite elevated supply and typical historical weakness during that month, the municipal bond market posted its best returns of the year and the best June return in 15 years, according to a report by BlackRock.
“June offered a testament to munis’ defensive nature and value as a portfolio diversifier,” analysts say in the report. “We attribute the continued support for the asset class to the investor desire for income and stability in a world of low-for-longer rates, as well as munis’ tendency to offer ballast from equity and equity-like risk.”
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Munis, as the bonds are known, generally have a better credit quality and default track record than cooperate bonds of the same rating, says Alan Schankel, managing director and municipal bond strategist at Janney Montgomery Scott.
“For investors looking for safety and security the bulk of municipal bonds issued in the market place are high quality,” says Michael Sullivan, vice president and institutional portfolio manager at Eaton Vance.
Diversification and tax benefits. Municipal bonds are typically not closely correlated with equities, are generally considered more defensive and tend to have lower volatility than stocks, says Mark Taylor, portfolio manager and head of municipal research at Alpine Woods Capital Investors. When the stock market tanks, investors tend to put money in munis alongside Treasurys, as they offer a level of safety of states and large cities that is just under the stability of the federal government, he says.
“They typically provide diversity in your average portfolio,” Taylor says.
In addition to a low correlation with domestic stocks, municipal bonds have relatively low correlation high-yield corporate bonds and international equities, Sullivan says.
In a downturn, corporate bonds may suffer because of worries over profits and sales outlooks, Schankel says. But the risk profile of munis is different, hinging on issues like sales and income taxes and property values.
But unlike Treasurys, income from municipal bonds is generally tax free. For example, New York City municipal bonds are tax free not only on the federal and state level, but also on the city level if you live in the five boroughs, Taylor says.
While municipal bond yields may be similar to yields on Treasurys — the 10-year Treasury is yielding 1.53 percent while AAA rated 10-year municipal bonds are yielding 1.37 percent — Schankel notes that the after-tax benefits on yields are substantial.
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Municipal bond risks. Risks with municipal bonds include credit risk of the issuer and interest rate risk, because a bond’s price goes down as interest rates rise, and vice versa.
Bankruptcy and defaults — such as the high-profile cases of Detroit and Puerto Rico — tend to be outliers, Schankel says. There is also the risk that municipalities and states could be downgraded because of credit issues, such as has happened with New Jersey, he says.
Although interest rates are a risk, moves by the Federal Reserve target short-term interest rates, but the further out bond maturities get, the less of an affect a Fed rate hike has, Schankel says.
He thinks interest rate risk on longer term municipal bonds is minimal over the next one to two years.
According to Sullivan, it doesn’t look like long-term interest rates will be moving higher because of factors including slow global growth and low inflation, although there is always the chance that could happen, he says.
Cities to consider. Schankel recommends that 30 percent of a fixed income portfolio should be dedicated to municipal bonds. Of that, he says, 25 percent should be investment grade and the remainder should be high yield.
Right now, San Francisco and Seattle offer high-quality bonds, but because they are on such good financial footing, they don’t have to pay much in yield, Schankel says. But cities like New York and Philadelphia, which are solid but not rated quite so highly, offer better earning potential, he says.
Taylor likes New York and Los Angeles for their manageable debt, unemployment rates in relation to state averages and how diverse their job base is. That diversity is important, he says, pointing to Detroit’s bankruptcy and noting that city’s reliance on the auto industry.
Some of the highest quality states include Texas and Massachusetts, and California has made a notable recovery since the financial crisis, Sullivan says.
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In addition to choosing a municipality or state in which to invest, investors also have to look at the credit quality of the issuing authority within the state. Water, sewer and electric utilities tend to be higher quality bonds, Sullivan says.
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How to Invest in Municipal Bonds originally appeared on usnews.com
