23 March 2011
By Joseph Lisanti
It’s no secret that the weak economy is causing severe budget crunches for state and local governments. No wonder many municipal bond holders worry about their investments.
Although there are reasons for caution, the state of the muni-bond world is not nearly as dire as the headlines would imply. In fact, experts say, the recent sell-off in municipal bonds could be a good opportunity for investors who can hang on in volatile times "Munis, on a relative-value basis, are looking pretty attractive: says Miriam Sjoblom, associate director of fixed-income research at Morningstar. She notes that yields are so good that managers of some taxable bond funds are buying munis.
Historically, tax-exempt bonds have delivered 85% of the comparable-maturity Treasury yield. In early February, a typical ten-year municipal offered 97% of the yield of a ten-year T-note. That muni, now delivering 3.55%, would be the equivalent of a 4.93% taxable bond yield for someone in the 28% bracket.
The high yields resulted from a sharp sell-off in munis that began toward the end of 2010. Some of the decline was related to default fears, but Hugh McGuirk, who heads the municipal bond group at T. Rowe Price, thinks that supply and demand factors were more to blame. First, low yields restrained demand. Then, the federally subsidized Build America Bond program ended; investors left the muni market, fearful that a flood of new tax-exempt issues would depress prices.
Headlines about budget ills have mostly affected the prices of general obligation bonds, which are backed by the taxing power of the issuing state. If you plan to buy munis, look for revenue bonds, which are backed by fees from essential services such as water and sewer.
If you already own individual bonds, defaults are unlikely and you should be immune from price fluctuations if you hold the bonds until maturity. When Ray Mignone, a certified financial planner in Little Neck, N.Y, reviews clients' individual municipal bond holdings, he looks at the credit quality and the maturity. If the quality looks good and the maturity isn't too far in the future, "we're just going to hold them," he says.
You can get the best diversification with a bond fund. "I don't think you would be very vulnerable to individual credit blowups," says Sjoblom. Among the muni funds Morningstar rates four stars are Vanguard Intermediate-Term Tax-Exempt (symbol VWITX, 0.20% expense ratio) and T. Rowe Price Tax Free Income (PRTAX, 0.53%), a long-term portfolio.
The Long and the Short of It
When it conies to fears of default by state and local borrowers, bond pros differentiate between short-term budget problems and longer-term cost pressures. States and localities must balance their budgets annually. But burgeoning public-employee pension and health-care costs will not cause investors trouble in the next couple of years. McGuirk says the states have "plenty of time" to address the long term issues.
Sjoblom argues that investors in intermediate-term muni funds who have a time horizon of three years or more should not be concerned about market volatility. She adds that people with a five- to ten-year projected holding period should consider long-term muni funds.
But if interest rates rise, won't holders of long-term bonds be punished? McGuirk contends that, because the yield spread between two-year and 30-year munis is a record 4.2 percentage points, the long end of the market will be less affected by Federal Reserve interest rate hikes than the short end.
Long-term bonds are more sensitive to inflation than to rate hikes, says McGuirk. If you think inflation will remain low, long-term munis could be attractive.
Mignone is not a fan of long-term muni bond funds. Starting last fall, he moved his clients out of them. He's not getting back in anytime soon because he expects the price of munis will continue to drop.
For clients in search of income, he currently recommends corporate bond funds and exchange-traded funds that track utilities. "The after-tax yield is less, but I believe over the next year or two the total return will be better," says Mignone.