Advisors debate how to make muni bond allocations count

A municipal bond allocation is often considered to be the foundation of a successful long-term investment portfolio, especially for high-net-worth individuals.

The big question facing financial advisors now is what type of municipal bonds should serve as the building blocks to create that foundation, especially in this new higher-rate environment.

Revenue bonds. General obligation bonds. High-yield munis. In-state. Out-of-state. They can all play a part in creating a municipal bond allocation.

The choices don’t end there. Advisors also need to decide how, where and for how long they want to own these critical portfolio ingredients. Should they buy municipal bond funds or individual bonds for their clients? And should the munis reside in a taxable or non-taxable account? They are tax-efficient, you know! And shoot, what about a muni bond ladder? And for what duration?

Yep, there are lots of questions swirling around this most basic of asset classes. The good news is that broadly speaking, the picture looks really sound in muni world.

“Most states have rainy day funds that are as high as they've ever been. So even if we're approaching some type of recession and tax receipts fall off, they have plenty of cash sitting in the bank to help cover any kind of shortfall,” said Scott Diamond, portfolio manager of the Goldman Sachs High Yield Municipal Fund.

When it comes to his favorite types of bonds currently trading in the market, Diamond, who also co-heads the municipal bond team at Goldman Sachs Asset Management, is a fan of so-called “special assessment bonds.”

“Think of it as a land-backed project. Single-family homes, those types of things. There's a shortage of homes. There's immigration to places like Texas and Florida, so I think that's an attractive sector,” Diamond said. “Charter schools have also been really interesting. They tend to be smaller and nonrated, so it’s very important to do your homework there.”

Melissa Cox, certified financial planner with Fetterman Investments, uses both individual bonds and bond funds for client portfolios, depending on the size of the accounts and their risk profiles. In her view, buying individual bonds is often the preferable alternative given fees and the opportunity for higher yields, as well as to minimize state income tax ramifications.

“In a rising interest-rate environment like we are currently experiencing, we focus on short maturities in the 3- to 18-month range to also minimize reinvestment risk. We consider our client’s state of residence and the income tax implications based on that state. For example, for clients in states like Florida and Texas that do not have state income tax, we can invest in tax-free municipal bonds that are in or out of state,” Cox said.

Conversely, if a client is a resident of New York City, Cox said she would invest in tax-free New York City muni bonds, which are considered triple tax-free.

While Cox buys individual bonds when possible, Herschel Clanton, president of Chancellor Wealth Management, is partial to using diversified bond funds in taxable accounts for clients in higher tax brackets.

“It's possible to find muni bond funds that specialize in single state portfolios. This is attractive if the client lives in a high-tax state, but there may also be real additional credit risk in a high-tax state. Buying individual bonds for a portfolio is roughly akin to grocery shopping at the convenience store. It's very inefficient,” Clanton said.

MUNIS IN AN IRA? REALLY?

Since the interest and capital gains in an individual retirement account are already tax-exempt, the prevailing wisdom is that there is little — if any — benefit to holding muni bonds in an IRA. Financial advisors are generally predisposed to stashing their clients' muni bonds in a regular account and saving the IRA for other investments that require a tax shelter.

Not so fast, said Chris Bravender, fixed-income manager at Prospera Financial Services.

“Many are unfamiliar with taxable municipal bonds, but they can be utilized in various cases, including in IRAs. Like traditional tax-exempt munis, taxable munis are generally safe, and they trade with yield spreads that often exceed comparably rated corporate bonds,” said Bravender, who also prefers to buy individual issues as opposed to bond funds, and often out-of-state.

“In traditional brokerage accounts, we will buy out-of-state munis for diversification and in some cases to uncover yield spreads that we can’t find in the state of residence. There are definitely dislocations in the markets at times where you can attain yields in out-of-state bonds that more than make up for the state tax you have to pay,” he said.

PUTTING IT ALL TOGETHER

When constructing portfolios for client assets that are nonqualified, Stephen Kolano, managing director at Integrated Partners, uses municipal bonds as the largest chunk of the fixed-income component given their tax-advantaged status. The universe and duration spectrum of municipal bonds are so attractive to him that he often uses munis as a substitute for Treasury bonds, and in some cases corporate bonds, to achieve his portfolio goals. 

“An important aspect to consider is the tax rate of the client and yield comparison between Treasuries and munis from a taxable-equivalent-yield perspective,” Kolano said. “At the current time, yields on Treasuries have moved up at the shorter end of the curve, such that below the 35% tax bracket, Treasuries pay more than the taxable equivalent yield on municipal bonds.”

For the record, Kolano has no problem using either muni bond funds or individual bonds to serve his portfolio-building purposes. Furthermore, there are situations, and levels of wealth, where he says a ladder of individual muni bonds makes the most sense, primarily when there are state-specific requirements and the client has primary residence in a state with higher taxes and, as a result, a larger supply of municipal bonds. 

Kolano added that there are also situations in which a commingled vehicle, such as a mutual fund or ETF, may be the right fit. That’s primarily the case when the client isn't able to meet the required minimums for a bond ladder. Even in those cases, however, there are still laddering options.

“A more common approach we’ve been implementing is to use defined-term ETFs to create bond ladders of defined maturity for individual clients. These are diversified baskets of municipal bonds that all mature in the same calendar year, and as such the ETF matures in December of a given calendar year. This has the benefit of individual bond characteristics and being held to maturity but being a diversified basket of bonds,” he said.

Kolano also incorporates high-yield muni bonds into portfolios, often in place of high-yield corporate bonds. He notes that often high-yield muni bond strategies are generating those elevated yields by using longer duration bonds rather than lower credit quality bonds. As such, he considers the duration of the bond strategy when sizing its position in the portfolio in relation to his outlook for interest rates. 

“Currently, there is an interesting difference between the Treasury curve and the muni curve in that the muni curve is steeper further out,” he said. “That means longer duration/high-yield muni strategies are providing attractive yields relative to the duration risk in comparison with longer duration treasury securities.”

On the other hand, Matthew Anderson, founding partner at Advocus Private Wealth, an affiliate of Summit Financial, generally avoids high-yield muni bonds, preferring instead to add risk elsewhere in a portfolio.

“We don’t view fixed income as an area where we’re looking to capture growth or boost investment income, so we don’t often pursue high-yield fixed-income solutions. We prefer to seek those risk/return attributes in other areas of portfolios, such as equities, alternatives or private investments,” Anderson said.