Municipal bonds used to be a “no brainer” for safe, insured, tax- free income, that is until the companies insuring them became suspect.
In 2008, people found out some bonds, stripped of insurance -- more than 60 percent of the municipal bonds issued -- were a higher risk than anticipated. This led to a mass flight of individual investors from the market. Prices dropped and it was a great time to buy higher quality bonds. Since then, interest rates have continued to drop, the financial health of some states and cities is in doubt, pending income tax increases on dividends have been delayed and some financial commentators have warned of upcoming municipality failures. Let’s look to see if municipal bonds are a good value today.
First, let’s review some reasons to own municipal bonds. The typical muni bond investor is interested in obtaining consistent, reliable, tax-free income. Prior to 2008, less than .3 percent of all municipal bonds defaulted as compared to 13 percent of corporate bonds. If the investor was in the 25 percent or greater tax bracket, the equivalent yield was equal to or greater than high quality corporate bonds.
In 2010, equivalent yields on municipal bonds bested treasury and high quality corporate bonds. New bonds were being issued at lower, less attractive, rates making existing bonds attractive. With expected dividend tax increases, prices on higher yielding bonds rose. Owning muni bonds was good, buying them was expensive. Today, prices are lower and there are opportunities to acquire quality bonds. The key is to identify bonds with acceptable returns and then properly assess the risks.
Managing credit risk, so you obtain the expected returns, is crucial. It has always been wise to evaluate the issuer’s ability to support the payments, now it is imperative. Some states and municipalities are weak financially and will be hard pressed to meet their debt obligations. Others have revenues from diverse sources including property, utility, sales and use taxes. A review of the revenue sources, their stability and the uses of income is required to determine if they are spending wisely and preparing for future expenses. Recent concerns about large pension obligations have opened people’s eyes to the need to evaluate long term costs. A good starting point is to obtain the underlying ratings for the municipality. Next, look at the specific sources of revenue supporting the bond payments. Revenue from fees on utility usage is probably more reliable than revenue from ticket sales at the ballpark. Are these sources of revenue dedicated to this bond payment or spread out over many expenses? On the expense side, what are their obligations and how have they managed previous budgets?
You also must address the risk of inflation increases eating into the value of your income stream. This can be done by purchasing bonds that mature prior to when you expect inflation to be a strong factor.
The bottom line is that there is homework to be done to evaluate bonds. Brokerages, such as Fidelity, offer listings of available bonds on their sites. You can obtain historical pricing and access to prospectuses from InvestingInBonds.com and the Financial Industry Regulatory Authority site, FINRA.org. Digging into municipal finances means reviewing public reports. If you are not willing to spend the effort to review these risks, consult with an experienced bond adviser.
Municipal bonds can be a good addition to your portfolio. They can diversify and improve your returns. If the returns are acceptable and you can manage the risks, it is a good time to consider additions. Most likely, tax increases will occur in the future making tax-free income more desirable. Finally, buying quality investments when prices have been pushed down across the asset class can pay benefits in the long run.
Tom Roberts, principal of A New Approach Financial Planning in Lakewood Ranch, can be reached at (941) 927-9590 or Tom@ANewApproachFP.com.