Investing in sewage-treatment plants and highway overpasses
isn’t always this consistently lucrative. Municipal bonds have posted gains for
10 consecutive months, the longest rally in state and local government debt
since 1992, according to Barclays.
Munis, which have a reputation for stability and safety, have returned 8.1%
this year, through Thursday, including both price gains and interest payments. That
tops the 4.1% return for ultrasafe U.S. Treasurys as well as the 6.4% for
highly rated corporate bonds and 4.5% for so-called junk bonds, both of which
are seen as riskier investments. Munis aren’t far behind blue-chip stocks.
Muni investors typically pay no federal tax on the
interest—and if they live in the state or city that issued the bonds, they can
often avoid those taxes, too. That makes helping governments build vital
infrastructure all the more attractive. Investors have responded to the rally
by pouring $18.2 billion into muni-bond funds through October, according to
Lipper, which tracks fund flows. By comparison, investors yanked $48.4 billion
out of munis over the same period last year. Muni bonds lost 2.55% in 2013. But
as with any investment, there are risks and other issues to consider before
jumping in.
Here’s what you need to know about making money and staying
safe in the $3.7 trillion muni-bond market.
Are Muni Bonds for
You?
Munis make the most sense for investors who pay a lot in
taxes and can use the bonds to lower their tax bill, says Rob Williams,
director of income planning at the Schwab Center for Financial Research at
brokerage firm Charles Schwab. In fact, even though munis typically have
lower yields than Treasurys or corporate bonds, they may provide more income
once you take the tax advantages into account. Many of the issuers also carry
strong credit ratings.
The higher the tax rate, the better munis can look. The
advantages can be even greater when state and local taxes come into play. Investors can use online calculators to help
with the comparison.
Which Munis Should You
Buy?
The seeds of the current rally were sown in the recession
and fed by fears over Detroit and Puerto Rico that have festered in recent
years as other jurisdictions such as Stockton, Calif., and Jefferson County,
Ala., sought protection from creditors in bankruptcy.
The debt problems made investors wary of muni bonds and
officials wary of issuing them, which has curtailed supply. This year, however,
demand bounced back. In October, when turmoil in the stock market sent many
investors fleeing for cover, yields on muni bonds dipped below 2% for the first
time in two years. Yields fall as prices rise. Investors, therefore, may be tempted to seek out
higher-yielding munis, which often means buying riskier debt or bonds that
won’t be paid off for a long time. Instead, investors should be patient and look
for short-term muni-bond funds, whose holdings typically mature in less than
five years.
If you buy a bond with a decent yield from a reliable
issuer, current prices shouldn’t be too much of a deterrent. Even though munis
are generally paying a smaller premium than usual compared with Treasurys, a
small advantage remains.
Funds or Individual
Bonds?
Brokers often mark up the price of municipal bonds they sell
to individual investors, and those markups can be substantial—and hard to
identify. The markups that funds pay tend to be much lower, because fund
companies buy in bulk and know the market.
As a result, muni-bond funds make more sense for most people.
Minimizing fees is “absolutely crucial” to maximizing gains from a low-yielding
asset like a municipal bond, she says. Funds also spread the risk by holding
bonds from many different issuers. That’s important because the incentives
built into muni bonds can encourage investors to concentrate their risk
Buying bonds from your home state often provides the biggest
tax breaks, but it also ties your bond investments to the same economy that
supports your job and the market for your home. As a result, buying a low-fee
muni-bond fund that holds bonds issued by a variety of state and local
governments. But be aware that owning a nationally diversified fund can
somewhat limit the tax benefits, because fund investors typically only get a
break on state and local taxes on the portion of bonds that come from their
home state.
What Are the Risks?
Even if you buy a fund, don’t dismiss the risk of default. As
yields have dropped, investors have pushed into riskier debt, including bonds
backed by payments from tobacco companies to states—bonds whose payments are
linked to the number of smokers, and could therefore default as smoking
declines.
Be careful not to take on too much municipal debt. Muni
bonds make up about 10% of the bond market, but comprise closer to 90% of many
investors’ bond portfolios. Whether you buy funds or individual bonds, don’t
expect this year’s rally to continue forever. At the same time, don’t get
spooked if prices fall.
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