Barely a year ago, the municipal bond market was tarred as a horrible investment. The expiring taxable Build America Bonds program had triggered an uptick in new issues that created a supply glut, bond rates were on the rise and analyst Meredith Whitney told "60 Minutes" that defaults would amount to "hundreds of billions of dollars." From October 2010 through January 2011, municipal bond funds saw net outflows of more than $33 billion, while a benchmark municipal bond index fell nearly 5 percent.
Rumors of the municipal debt market's death were way off base. The default wave didn't materialize and munis staged an impressive rally as U.S. bond rates tumbled across the board. The 10.7 percent total return for the Barclays Municipal Bond index in 2011 squashed the 2.1 percent total return of the S&P 500-stock index. It also bested the 7.8 percent return of the Barclays Aggregate Bond index, the benchmark for taxable bond investments that's mostly composed of government and corporate bonds.
Pimco's Muni Move
That muni bonds are alive and kicking was underscored when Pacific Investment Management Co., which runs the world's largest bond fund, boosted its holdings of U.S. muni debt to the highest level in more than five years, according to data compiled by Bloomberg.
It's not that Joe Deane, who manages $16 billion as head of municipal-bond investments at Pimco in New York, expects a repeat of 2011 returns. More likely is a return of 6 percent to 7 percent this year, he told Bloomberg.
The reason for lower return expectations: After hitting a late 2010 high of 3.6 percent, the yield on AAA rated 10-year municipal bonds is now 1.8 percent. From that level, it's unrealistic to expect much in the way of price gains that come from falling yields. James Kochan, chief fixed-income strategist at Wells Fargo Funds, expects muni total returns in 2012 to be in line with the coupon interest paid. “We're not likely to get price appreciation on top of that.”
That means you might get 1.9 percent if you stick to a 10-year AAA rated municipal bond, close to what a 10-year Treasury pays out. Of course, if you're investing in taxable accounts, the 1.9 percent muni yield is worth a lot more because its interest payout isn't subject to federal income tax, while Treasury bond income is. The 10-year Treasury would have to pay 2.6 percent to be a better deal than the muni for an investor in the 28 percent federal tax bracket, or 2.9 percent for someone in the top 35 percent federal marginal tax bracket.
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Bond pros say there's an opportunity to pocket even more yield. “Go down the credit scale just a little bit and you can pick up sizable yield advantages over Treasuries,” notes Chris Alwine, head of Vanguard's municipal bond team. Don't worry, this isn't about venturing into junk. Rather, all you need to do is set your sights on the lower tiers of investment grade bonds, he says: AA, A and BBB.
For example, 10-year single A rated tax-exempt bonds yield 3 percent, Kochan points out. That's 150 percent of the Treasury bond, a rich advantage given that the average for 20 years prior to the financial crisis was 90 percent. For investors in the 28 percent bracket, that 3 percent is the taxable equivalent of 4.2 percent. If you're paying the top tax rate of 35 percent, you'd need to earn 4.7 percent in a taxable bond to match the 3 percent muni yield. Good luck finding that in the high-grade pool these days. The Bank of America/Merrill Lynch index of investment grade corporate bonds has a yield of 3.8 percent.
One obvious risk bond pros note is that you can only get those fatter yields in intermediate and longer-term issues. “But we've got a very benign interest rate environment with the Federal Reserve holding rates low through at least the middle of 2013,” says Anthony Valeri, fixed-income strategist at LPL Financial. He also notes that the extra yield on longer issues will provide some buffer if we see a rise in rates this year. “It's just too early in the cycle to be overly cautious about rising interest rates,” says Kochan.
Diversified Funds
Municipal bonds are one investment where hiring a professional fund manager makes a ton of sense. They have the analysts to ferret out good investment-grade values, and you get the broad diversification that helps mitigate default risk. Fidelity Intermediate Municipal Income (3.35 percent yield; $10,000 minimum; 0.39 percent expense ratio) and Vanguard Intermediate Term Tax-Exempt (3.51 percent yield; $3,000 minimum; 0.20 percent expense ratio) earn high marks from fund research firm Morningstar. Another option is the iShares S&P National AMT-Free Bond Fund, the biggest exchange-traded fund tracking municipal bond debt, which is trading near a record high.
Franklin Federal Tax-Free (4.27 percent yield; $1,000 minimum; 4.25 percent initial load and 0.62 percent expense ratio) also gets the nod from Morningstar. Co-manager Carrie Higgins says the fund gets "substantially more yield in the 10- to-20-year range." Its yield advantage over the Vanguard or Fidelity funds comes from focusing on longer-term bonds. The fund's portfolio has an average maturity of 20 years, about four times that of the Vanguard and Fidelity intermediate portfolios. Its expenses are also significantly higher.
That extra yield may be enticing. In volatile periods, however, a concentration in longer muni bonds can work against investors. For example, in 2008 the Franklin fund's total return was a negative 7 percent, while the Fidelity intermediate portfolio lost 0.96 percent and the Vanguard fund lost 0.14 percent.
--Bloomberg News--
