Municipal bonds: Not sexy, but always important

Some may be riskier than you realize, but don't let that chase you away.

By Leslie Kane
Senior Editor

Investors thought they'd found a safe haven with municipal bonds issued by the Spokane [WA] Downtown Foundation in 1997. The bonds offered 5 percent interest—good at the time, and the equivalent of 8.3 percent after-tax return for people in the 39.6 percent marginal tax bracket.

Trouble was, the parking garage the bonds financed couldn't cover its costs, and a battle broke out over whether the facility was truly for public use. The issuer stopped paying interest, and the bonds went into default. Bondholders lost most of what they'd put in.

"Some municipal bonds are far riskier than people realize," says Jack Colombo, editor of the Defaulted Bonds Newsletter, in Miami Lakes, FL. "High-quality bonds can lose their credit rating over time, projects can run into problems, and financial hanky-panky sometimes takes place in the unrated bond arena."

Most municipal bonds, though, are quite safe, and they can play an important role in your non-tax-sheltered portfolio. You need bonds because they move out of sync with stocks. Often they're up when equities are down, and that seesaw effect helps lessen your overall portfolio risk. You need municipals because you generally don't pay federal tax on the interest. As a bonus, if you buy municipal bonds issued by your state of residence, you usually don't pay state tax on the interest, either.

In today's dismal stock market, returns on municipals look quite good. The Lehman Brothers Municipal Bond Index returned 10.0 percent federal-tax-free in the 12 months through June. Earn that return now and you'll have an annualized equivalent of 16.4 percent, if you're in the 38.6 percent tax bracket—the new top rate for the second half of 2001. The Standard & Poor's 500 Stock Index lost 14.8 percent during the same 12-month period.

"When stocks brought 25 percent annual returns, tax-free bonds seemed boring," says Robert Beck, a principal of Edward Jones, an investment firm based in St. Louis. "People now realize that diversifying into these bonds would have softened their portfolios' drop."

When a muni bond and a taxable one pay the same rate after tax, you're generally better off with the muni, says William A. Hornbarger, a fixed-income strategist with A.G. Edwards & Sons, a brokerage in St. Louis. That's because munis tend to be safer. "For identical after-tax yields, the municipal bond may have a triple-A rating—the highest credit quality—while a corporate bond has only an A rating, which is still good, but less so."

To compare the return of a municipal bond with that of a taxable investment, subtract your marginal tax bracket percentage from the number 1. Then divide the municipal bond's yield by the result to get the taxable equivalent. If you're in the 38.6 percent tax bracket, you'd subtract 0.386 from 1 to get 0.614. Next, if a bond yields 6.3 percent, you'd divide 6.3 by 0.614 to learn that the muni bond's interest equals 10.3 percent from a taxable investment. Or use the calculator at The Bond Market Association's Web site, www.investinginbonds.com. Keep in mind that for 2001, the calculation will be close but not exact, because the marginal tax brackets changed mid-year.

How to choose winning muni bonds

Choosing municipal bonds can be tough. About 1.5 million issues sold by 50,000 local governments are traded by at least 2,000 securities dealers. Ask your broker or financial adviser for recommendations. You can also find and buy these bonds online through most brokerages. Here's how to be a smart buyer:

Stick with local bonds, in most cases. Most states allow a local tax exemption as well as a state exemption on municipal bonds issued within their borders, so local bonds are usually your best bet. However, Alaska, Indiana, Nevada, South Dakota, Texas, Utah, Washington, Wyoming, and the District of Columbia offer tax exemptions on municipal bonds from outside their borders, as well.

Pay attention to maturity dates. Bond maturities range from one day to about 30 years. The longer the maturity, the greater the risk. "Interest rates could rise, so if you lock in a rate, you may miss out on a better yield," says Alexandra Lebenthal, president of Lebenthal & Co., a brokerage firm in New York. "Also, if stocks rebound to 25 percent annual gains, you'll earn less in bonds. And the new tax brackets may affect the value of your bonds."

Choose bond maturities based on when you want the principal repaid, and on your desired investment return. To offset risk, use a laddered approach, selecting bonds with sequential maturities so that some mature every year. "That lets you reinvest at the going rate, and gives you some protection against falling interest rates," says Lebenthal.

Choose government-backed bonds. General obligation bonds are secured by the local or state government's authority to levy taxes or dig into real estate or other tax payments, in order to fund bond coupons. Default risk is virtually nil.

Revenue bonds, however, are supported only by earnings from the project being financed. If the project fizzles or dies, interest payments could stop and the bond could go into default. "Revenue bonds are far riskier than general obligation bonds," says newsletter editor Colombo.

Industrial revenue bonds, often used by communities to lure new businesses, pose the greatest danger. "A local government may issue tax-free revenue bonds backed by a company, if the company convinces the government that a project will create jobs and improve the community," Colombo says. "But the company's assets may be shaky." Hence the 14.9 percent default rate on industrial revenue bonds.

The bond's prospectus will tell whether it's a general obligation or revenue bond. If you're considering a revenue bond, get an annual report on the company running the project, if possible. Also, find out the fate of its prior projects.

Buy only top-rated bonds.Ratings help you predict whether the issuing entity will be able to make its scheduled interest payments. Look in a financial newspaper, or go to www.investinginbonds.com , where you can search by state for bonds with your desired maturity, rating, and coupon (interest rate). Other sources are Moody's Municipal and Government Manual and Standard & Poor's Blue List, which may be available at a college business school library. Your financial adviser may have access to them, too.

Moody's highest rating is Aaa; the top Standard & Poor's ranking is AAA. The lowest investment-grade bond ratings in both systems are Baa and BBB, respectively. Lower-rated bonds, known as junk bonds, offer high yields to tempt investors, but carry higher risk of default. Steer clear, unless you get them in funds (see below).

"Even an A-rated bond could deteriorate over time," says Hornbarger. That happened to a bond issued by the Santa Rosa Bay Bridge Authority; it dropped from investment-grade to junk, before defaulting a year later. Still, starting strong improves your odds.

Avoid unrated bonds. In some cases, to save the expense of paying a rating service, issuers don't seek a rating; more often, such issuers know that a rating would be the kiss of death.

Favor insured bonds. "Buying triple-A insured bonds is pretty much a slam dunk investment," says Colombo. "If the bond defaults, the insurer guarantees to pay the interest and principal. About half the municipal bonds issued are insured."

Robert Beck, of the Edward Jones investment firm, adds: "Only bonds that are highly creditworthy can get insurance. Insurance boosts the bonds' desirability. A double-A-rated bond becomes triple-A rated if it has qualified for insurance." Insured bonds sometimes pay a slightly lower coupon than uninsured bonds, says Beck.

This doesn't mean uninsured bonds aren't worthwhile. "Smaller issues, say $4 million, may find it cost-prohibitive to get insurance, or an insurance company may refuse coverage simply because the issue's so small. But the bond's still creditworthy," Beck says. However, you're wise to pass on uninsured bonds unless you know the backing company's financial status inside and out, and the bond's coupon makes taking a bit of extra risk worthwhile.

Be wary of sky-high interest rates. "If AAA-rated insured munis are getting 4.5 percent, and a bond's prospectus promises 10 percent, alarm bells should go off," says Colombo. The high return undoubtedly means high risk.

Check the fine print. Transaction costs usually run $5 to $30 per $1,000 invested, depending on the broker, the size of the order, and the maturity of the bonds. Costs could be higher, though, for odd lots, low-rated bonds, or bonds with few pro-spective buyers.

Be sure you're getting what you think you are. Returns on some municipal bonds, such as those for a local sports facility, say, are taxable at the federal level, because the government won't subsidize the financing of activities that don't significantly benefit the public at large. However, these bonds still offer a state and local tax exemption to state residents.

Why muni funds may be your best bet

Alexandra Lebenthal

If you want municipal bonds but not the bother of buying staggered maturities—or you want to shoot for higher returns than you can get from triple-A-rated municipals—consider funds.

Since bond prices fluctuate in response to current interest rates and changing credit ratings, portfolio managers trade actively to get the highest returns, which you can rarely get with a buy-and-hold strategy. And because the fund manager deals in bonds with varying maturities and credit ratings, you get instant diversification. Also, you'd need to invest a substantial sum in individual bonds to create an equally diversified portfolio.

Many municipal bond funds that generate higher returns contain high-yield or "junk" bonds, which require active management. Those bonds, which have credit ratings that are below investment grade, face a relatively high prospect of default.

"Municipal bond funds make tremendous sense for an investor who is saving for a long-term goal in a taxable account, doesn't need income, or has small sums to invest over time," says Alexandra Lebenthal, president of Lebenthal & Co., a brokerage firm in New York. Although many bond funds pay interest, you can choose to have it reinvested in the fund.

With municipal bond funds from your own state, earnings are exempt from state and local as well as federal taxes. Such funds aren't available for every state, though, so you may have to opt for a national fund, which contains munis from many states.

The 12-month returns for national municipal bond funds average 8.8 percent; annualized five-year returns average 5.3 percent. Those figures represent total return, which includes interest plus capital gains or losses through change in bond prices.

 

Leslie Kane. Municipal bonds: Not sexy, but always important. Medical Economics 2001;15:44.