Great stocking stuffers: Muni bonds

Wealthy U.S. investors may be able to buy municipal bonds at some of the highest yields in seven months as issuers rush to borrow before year end. Yields on the second-highest-rated municipal debt were at levels not reached since May, according to a Bloomberg Fair Market Value index as of Dec. 6. Tax-free securities declined 2.29 percent last month, according to the Bank of America Merrill Lynch Municipal Master Index. That was the third straight monthly drop, which hasn't happened since 2004, the index shows. “There will be opportunities for astute investors to buy good quality bonds at lower prices,” said Randy Beeman, managing director of Robert W. Baird & Co.'s The Wise Investor Group, which oversees almost $2 billion in client assets. Munis of all maturities are “relatively cheap” right now, with yields in short-to-intermediate term securities particularly high compared with Treasuries, according to fixed-income strategists at New York-based JPMorgan Chase & Co. in a report dated Nov. 19. The bank's analysts raised their recommendation on tax-exempt munis to “cautiously positive” from “neutral.” Bond yields rise as prices fall. Prices are lower in part because of a heavy supply of bonds as issuers work to meet the Dec. 31 deadline to receive a 35 percent federal subsidy through the taxable Build America Bond program, said Richard Saperstein, managing director at Treasury Partners in New York, which oversees $10 billion in assets. Bond Supply When municipal issuers sell Build America Bonds, the deals are frequently combined with tax-exempt issuance, Saperstein said. States and municipalities borrowed about $39.6 billion last month, according to data compiled by Bloomberg. Top-rated tax-exempt munis due in 10 years were yielding 2.78 percent as of Dec. 6, according to a Bloomberg Valuation index. For the highest earners paying a 35 percent federal rate on income, a 2.78 percent yield on the securities is equivalent to a 4.28 taxable yield. Investors should buy selectively while also being mindful of the risk of credit downgrades or defaults, according to Beeman, who's based in Reston, Virginia, and works with clients who have an average net worth of about $5 million. Strategies include switching to individual bonds from funds and diversifying holdings among states. Fund Outflows Withdrawals by municipal bond fund investors last month also helped to lower prices. Mutual fund investors sold $5.4 billion of muni assets within two weeks last month, according to Lipper FMI, a research firm. David Schwartz, a physician based in Atlanta, kept his investments in high-yield municipal bond funds last month even though his accounts with Fidelity Investments, Vanguard Group Inc., T. Rowe Price Group Inc. and American Century Investments lost as much as 5 percent, he said. Schwartz, 57, said he has a “significant percentage” of his non-retirement savings in munis, without giving a figure, and bought more on Dec. 1. “I decided to invest additional monies in high-yield bonds because share prices and yields were attractive,” he said. “Municipal bonds still have a low default rate and tax rates may rise on the highest earners, which may make the bonds more desirable.” Municipal bonds are generally exempt from federal taxes as well as state and local levies for residents in most states where they're issued. Financial Stress While states and municipalities are coping with financial stress at “a level that has not been seen for decades,” defaults will continue to be isolated situations, said Fitch Ratings in a Nov. 16 report. The average default rate for investment-grade municipal debt evaluated by Moody's Investors Service from 1970 through 2009 was 0.03 percent, compared with 0.97 percent for corporate issues, the New York-based company said in February. Defaulted securities fell to $2.48 billion through October, compared with $7.28 billion in all of 2009, according to data from Richard Lehmann, publisher of Distressed Debt Securities Newsletter. Investors may want to consider buying individual bonds now rather than mutual funds or exchange-traded funds, said Paul Tramontano, chief executive officer of Constellation Wealth Advisors, a New York-based advisory firm with about $4 billion in assets. ETFs generally track an index and trade on an exchange like a stock. Investors with at least $500,000 to construct an account of individual bonds will have the ability to diversify by purchasing at least 20 different securities in $25,000 lots, said Tramontano. Investing in funds may mean investors will be trapped in longer-dated or lower credit bonds than they'd like, Tramontano said. Muni ETFs Municipal bond ETFs may also experience bigger drops than the indexes they track because the share price can vary more than the value of the bonds in the fund, said Robert Kane, founder of BondView, a website that provides information to retail municipal bond investors. The iShares S&P National AMT- Free Municipal Bond Fund hit a 16-month low of $100.40 on Nov. 16 and fell 2.79 percent in November compared with a 2.25 percent drop for the index it follows. Investor behavior is a risk of investing in funds, said Jason Thomas, chief investment officer at Aspiriant, a multifamily office based in San Francisco with about $7.5 billion in assets. “If I own the bond directly I can hold it through whatever volatility,” said Thomas. “If I'm in a bond fund and all the investors get scared and leave that can impact my performance.” Revenue Bonds Revenue bonds are attractive because they have dedicated sources of repayment such as water and power districts, transportation systems and industrial development, and may offer higher yields than general obligation bonds which are supported by tax revenue of the state or municipality, said Thomas. Investors can potentially pick up additional yield from revenue bonds in states such as California and Illinois that have suffered from mounting budget deficits. That's because these issuers may offer higher yields even though their income stream is independent from the state's budgetary woes, said Saperstein of Treasury Partners, a division of Chicago-based HighTower Advisors. Kane of BondView said he likes essential service revenue bonds, such as those issued by the Puerto Rico Electric Power Authority, rated BBB+ by Standard & Poor's, or the third lowest of 10 investment-grade ratings. The bonds offer investors an exemption from any state tax, and provide higher yields because they're rated lower than many municipalities. Diversify States Investors should diversify and own bonds from other states, especially those with better credit ratings, such as AAA rated Virginia and Maryland, and forfeit the state and local tax savings, said Beeman of Robert W. Baird. Credit downgrades or investor panic could still drive down bond prices, said Paul Jacobs, a certified financial planner who works in the Atlanta office of Palisades Hudson Financial Group, which manages more than $1 billion for 55 families. State tax revenue rose 3.9 percent in the third quarter from a year earlier, the third consecutive gain, as a recovering economy boosted receipts from sales and personal-income levies, according to a study of 48 states by the Nelson A. Rockefeller Institute of Government in Albany, New York. ‘Smoldering Debt' Albert Lewis, a former retirement planning specialist for Morgan Stanley who lives in Elephant Butte, New Mexico, said he started reducing his municipal bond holdings six months ago because he feared the issuers wouldn't be able to pay. “There may be some great bargains out there,” said Lewis, 69, who had $300,000 invested in individual municipal bonds. “But there are also lots of unidentified smoldering debt beneath the coffers of many a municipality.” Investors who stay in the muni market should consider putting up to 35 percent of their municipal investments in intermediate-term securities, or bonds with 7-year to 10-year maturities and higher yields, said Constellation's Tramontano. The bulk of the portfolio should remain in shorter-termed munis because of the potential for rising interest rates, he said. —Bloomberg News—