Munibond Maniacs, Beware


For almost a year now, investors have been flinging money at municipal bonds like they were $20 iPads.

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In the week ending Oct. 10, U.S. munibond mutual funds had their biggest week since April, with nearly $915 million in new inflows, according to Lipper, a Thomson Reuters company. Individual investors bought 1.9 bonds for each one they sold.

Maybe those investors were attracted to the outsized returns these traditionally "safe" investments have been delivering. General and insured munibond mutual funds have had total returns of 7.89% so far this year, compared with the 2.75% total returns logged by Treasury funds, Lipper said. Last year those same munifunds returned 11.29% to investors, while the Treasury funds returned 7.11%.

But munibond experts aren't over the moon. They are looking at city bankruptcies in California, downgrades and warnings from ratings agencies such as Moody's Investors Service, and the possibility that a healing economy will produce rising interest rates, which will drive down bond prices. As the Jetson's dog Astro would say, "Ruh roh!"

"Investors have missed the boat, they really have, but they continue to pour money into the whole tax-free market," says Marilyn Cohen, a money manager who specializes in bonds and has a new book out with the troubling title, "Surviving the Bond Bear Market: Bondland's Nuclear Winter."

New munibond investors "are going to be the last people in the pool," she warned.

So, if you've never been a munibond buyer before, maybe this isn't the best time to start. But if you're in a high tax bracket, or you've already amassed a munibond portfolio and you're getting nervous, read on for some protective advice.

-- Munibonds do convey tax advantages. Their interest payments are exempt from federal income tax as well as state and local taxes in the places where they are issued. That's why, even though they typically yield less than Treasury bonds, they can be worth it for high-bracket investors. Interest on Treasury bills, notes and bonds are exempt from state taxes but not federal taxes. And most recently and often during the last year or so, munis have actually had higher yields than Treasuries. Last week, 10-year Treasuries were yielding 1.659% while 10-year munis were yielding 1.88%, according to data compiled by Robert W. Baird & Co.

Furthermore, muni interest will also be exempt from the new 2.3% Medicare surtax on investment income, due to hit high earners starting in 2013. That means individuals earning more than $200,000 ($250,000 for couples) have new reasons to flock.

-- Many state, local and municipal budgets are troubled, but not all. Most of the recently announced bankruptcies and downgrades have been in California; Illinois localities also are at risk, says Cohen. But Alan Schankel, head of fixed income research and strategy at Janney Capital Markets, notes that the bonds in question thus far are "not a huge amount in the context of the $3.7 trillion munibond market."

That means Californians who have a lot invested in triple-tax-free bonds might consider giving up some of the state and local tax breaks and moving into bonds issued elsewhere. Of course anyone buying individual bonds has to do due diligence and study the particulars of the place they are buying bonds from.

-- Some bonds are more equal than others. This isn't the time to reach for yield and invest in specialized so-called revenue bonds that are backed by specific projects, like, ahem, a parking garage at Yankee Stadium that has been suffering a cash shortage. Focus on general obligation bonds that states/localities stand fully behind, even if their yields are somewhat lower.

-- Use diversification strategies. Schankel tells investors to ladder their individual bonds. That means spreading out their maturities so that some of your bonds mature every year, for 10 years out. Whenever rates start to rise, you'll have some bonds maturing every year that you can invest at higher rates.

Diversifying across municipalities also takes the portfolio pressure off any one issuer.

You can accomplish much of that diversification by buying into a munibond mutual fund instead of buying individual bonds. When you do that you can get whacked when rates rise, because your fund won't have a maturity date on which you can get your initial investment back. But you will always have money coming in that can be reinvested at higher rates.

"I'm not a fund advocate, but right now that might be the lesser of all evils," says Cohen. "Look at exchange-traded funds now instead of individual issues. That way, you can point, click and get out in a hurry if you have to."

-- Other risks loom. Munibond investors may already know they should keep an eye on rising interest rates and strapped localities. There are more long-term risks that should be part of the calculus, too. One of them is the big federal spending cuts slated to go into effect early in 2013. They will hit places like Virginia that have big defense industries particularly hard, says Schankel, who notes that the state is fairly wealthy and shouldn't have trouble paying its bills.

The second long-term risk might be such a long shot that many investors will shrug it off: That is the risk that Congress and the White House will work together in a bipartisan way (stop laughing/crying) and reform the personal income tax system in a way that results in lower income-tax rates. Should that happen, the benefits conveyed by tax-free investments would shrink, and their prices could be expected to fall accordingly. Watch that space.