"More Investors, Chastened by Stock Losses, Settle for Municipal Bonds
THE historic lure of most municipal bonds has been their tax-free returns. But the recession and the rash of corporate troubles have widened their appeal to investors wary of the stock market who want to settle for a steady if unspectacular return.
Municipal bonds are still the terrain of high earners, who like their safety and higher tax-adjusted return than Treasury bonds. But increasingly average retail investors have been buying them to fill out their bond allocations. “Our average account has increased their asset allocation in fixed income to 52 percent and most of that is in munis,” said Robert Everett, director of fixed income at the Boston Private Bank and Trust Company. He said that was an increase of 15 percentage points from last year.
Even though the major stock markets have risen in the last month, uncertainty about the rally abounds. Suddenly, the return on a municipal bond of 6 to 7 percent, including the tax exemption, seems great.
The other draw has been safety. Historically, the default rate on investment-grade munis is less than a quarter of a percent, compared with almost 2 percent for corporate bonds. And the difference in yield between United States Treasuries and munis has recently been as much as 2.5 percent.
Given the pressure on city and state coffers, the default rate is likely to rise closer to 1 percent. But that is far lower than the yields on munis suggests, said George Strickland, a managing director at Thornburg Investment Management of Santa Fe, N.M. “The market thinks 20 percent of investment grade issuers will default in the next 10 years,” he said. “The major muni issuers are doing well.”
Being selective with munis is key. The first risk investors need to understand is the difference between general obligation and revenue bonds. General obligation bonds are sold to finance the daily operations of a municipality. Legally, that entity is obligated to do whatever it needs — from cutting services to raising taxes — to make its bond payments.
A revenue bond is sold to finance particular projects like hospitals, utilities and stadiums. The receipts from such projects are used to make the bond payments, and many investors have started to wonder how these will hold up.
“Stay away from revenue bonds, backed by projects like a parking lot at a university,” warned Gregg S. Fisher, chief investment officer of Gerstein Fisher, an investment advisory firm in New York. “If cars stop showing up, then you could have trouble getting your money.”
Hospital bonds also need to be evaluated carefully. “Community hospitals with A and BBB ratings are feeling the pinch because people without insurance go to them and can’t pay,” said Ronald J. Sanchez, director of fixed income strategies at Fiduciary Trust, a unit of Franklin Templeton Investments. “You need to avoid certain segments with greater risk.”
This points to another issue: liquidity. Roughly $360 billion of new bonds are sold annually. New York and California are the benchmark issuers and their bonds are traded often. But there are scores of municipalities that sell bonds that buyers may have to hold for their duration because of illiquid markets.
Munis are traded in an over-the-counter fashion, which means finding a price quote, let alone a buyer, can be difficult at times. Although small investors make up a good part of this market, the Securities and Exchange Commission has no role in its regulation.
But for those aware of the risk, there are investing opportunities. During the first quarter, few municipalities sold bonds because they were waiting to see what the stimulus plan would bring them. Now, cities and states are making up for lost time.
Several portfolio managers advise that shorter-dated munis are safer. “The longer the duration the more volatility,” said Mr. Strickland, who likes the two- to three-year range.
Diversification is also being pushed for munis. Historically investors have concentrated on bonds from their state to get the full tax deduction. But owning bonds from other states could give them a greater return, as in the case of California, where a fiscal crisis has pushed up yields.
The recession has brought about new securities, known as Build America Bonds, to help ailing municipalities raise money. They allow municipalities to sell taxable bonds for capital projects while receiving a rebate from the federal government for a portion of their borrowing costs. The program is meant to attract institutional investors who typically do not buy munis. But they could also suit a retail investor who wants to put them in a taxable retirement account."