Now's the Time to Embrace Municipal Bonds

By Jane Bryant Quinn
Sunday, November 30, 2008

Investors may have jumped out of their tax-exempt bond funds at just the wrong time. They poured a net of $20 billion into municipal funds this year. Then, in late September, they changed their minds. So far this quarter, $7.4 billion has fled the scene, reports Robert Adler, president of AMG Data Services, which tracks fund flows.

As investments, munis remain spectacular. You can get as much as 5 percent on AA-rated 10-year issues. That's the equivalent of 6.7 percent in the 25 percent federal tax bracket and 7.7 percent in the 35 percent bracket. Yields go higher than that if the bonds are also free of state and local taxes.

Tax-free mutual funds are also buying these super-high interest rate bonds. But funds have to mark the value of their bonds to the daily price changes in the market. During the credit collapse, fund performance turned ugly.

When interest rates rise, bond prices fall. Three-month returns on national, long-term tax-exempt funds, which contain the bonds of all states, are down 6.5 percent, according to Morningstar Investment Services. High-yield funds, which buy lower quality and unrated issues, lost 13.9 percent. Investors balked.

Looking just at this past month, however, the national funds reversed their decline and rose 3.31 percent. The high-quality funds have built in a high current return with the potential for high capital gain, said Gus Sauter, chief investment officer for the Vanguard Group. They own those 5 percent bonds you're dying to have.

Among the lesser-quality bonds, trouble lurks. Historically, defaults have been minuscule, but that was then and this is now, said bond specialist Marilyn Cohen, chief executive of Envision Capital Management in Los Angeles. She expects a far higher number of defaults and credit downgrades in this recession than we've seen before.

High-yield muni funds -- especially popular with retail investors -- will continue to be at particular risk. In good years, they produce gorgeous returns but give it all back when bond prices fall. Over the past five years, high-yields have returned exactly zero compared with 1.39 percent a year for the higher-quality funds, Morningstar reports. Vanguard's conservative, High-Yield Tax-Exempt Fund has underperformed its high-quality intermediate-term fund over one, five and 10 years. So why would you bother chasing yield?

Investors spooked by price volatility prefer to hold individual bonds. They also fluctuate in price but you don't see the changes so you don't lose sleep.

You might lose money, though, if you have to sell before maturity. For that reason, advisers recommend against locking yourself into 20- or 30-year bonds. Look at intermediate five- to 10-year terms.

General-obligation bonds, backed by taxing power, rank as the safest munis -- safer than their high current yields would indicate, said Richard Larkin, research director at Herbert J. Sims & Co., a municipal-bond firm in Iselin, N.J.

Revenue bonds, backed by particular streams of income, can also be safe if they're linked to essential services, such as water treatment and sewer systems. Cohen recommends investing only in the revenue bonds of mature cities and suburbs, not in planned new developments that might not pan out. Always check the source of the revenue in the bond's official statement (ask the broker for it). A muni issued by a city, which seems safe, may be backed by a risky source of revenue, such as a stadium or shopping development.

Don't limit yourself to insured municipals. They've lost their mojo. Today, muni bonds sell on their underlying ratings, not on the ratings of their tattered insurance backers. Vanguard will eliminate its insured bond fund next month, merging it into the Vanguard Long-Term Tax-Exempt Fund. AllianceBernstein will combine its Municipal Income Fund Insured California Portfolio with its regular tax-free California Portfolio.

Munis are especially good for constructing ladders, because, for now, they're paying more than taxable Treasuries. In a ladder, bonds come due serially over several years. If you don't need the money on a bond's due date, you can reinvest. Planner Jonathan Krasney of Krasney Financial in Mendham, N.J., is currently using five-year ladders of actively traded munis rated A or BAA by Moody's. The lower credit quality isn't a problem, he said, because of the short maturities.

There are other ways of indulging in munis that you might consider:

· Exchange-traded funds -- the largest being iShares S&P National Municipal Bond Fund. They're not a best buy. You pay 0.25 percent in expenses plus brokerage commissions, compared with 0.15 percent for Vanguard's Intermediate-Term Tax-Exempt Fund with no commissions. Vanguard's fund is down just 0.49 percent for the year, compared with 2.58 percent for National Municipal Bond Fund.

· Closed-end muni funds -- avoid them, for now, said Cecilia Gondor, executive vice president of the closed-end research firm, Thomas J. Herzfeld Advisors in Miami. They're best bought at large discounts from the net-asset value of the securities they hold. The last big buying opportunity came on Oct. 10, during the market panic, when average discounts reached 26 percent. Since then, discounts have narrowed to 12.7 percent. Gondor expects some issues to exceed 20 percent again, during year-end tax selling and after some of the funds announce dividend cuts.

· Pre-refunded municipals -- for absolute safety from default. These bonds were issued years ago at higher rates. When interest rates fell, in the early years of this decade, municipalities issued new bonds, used the proceeds to buy Treasuries, and escrowed the Treasuries to support the older bonds. The escrow account pays the interest and the principal on the bonds when they come due, usually at their first call date.

It's like buying tax-free Treasuries, Cohen said. They generally, but not always, pay slightly less than a comparable general-obligation bond.

Two years ago, fixed-income investors forgot that risk was in the world, said Morningstar's senior mutual fund analyst, Lawrence Jones. They're remembering now.

Jane Bryant Quinn, author of "Smart and Simple Financial Strategies for Busy People," is a Bloomberg News columnist. Alexis Leondis contributed to this column.

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