Many Wall Street pros have long held that for safety in a quiet, even boring, sector of the market, with steady tax-sheltered income to boot, municipal bonds were the way to go.
What a difference a year makes. Since the financial crisis began last summer, the muni bond market has been anything but dull.
The total return on municipal bonds fell into negative territory in 2008 for the first time in a decade – but then snapped back with a 6.3% total gain from December through April, outperforming stocks and U.S. government bonds over the same period.
“It’s been quite a run,” said Jamie Pagliocco, a municipal bond portfolio manager with Fidelity Investments, adding that “there’s been more volatility than in the past.”
The gyrations have ended, and the big bounce back from severely depressed levels is unlikely to continue, money managers and bond strategists said, though there is still a case to be made for owning tax-free municipal bonds.
Munis can pay the taxable equivalent of more than 6% for those in the highest tax brackets – and with tax rates rising, such investments become more valuable. Indeed, with municipal yields not far from the yields on comparable taxable bonds, they may offer an attractive source of income for many portfolios.
Struggling states
The relatively high yields of munis right now reflect problems that state and local governments face.
Exhibit 1 is California, which faces a $24 billion budget deficit, and is desperately slashing spending. At least 46 other states are struggling to make ends meet, according to the Center on Budget and Policy Priorities, a Washington think tank.
State and local governments rely on bonds to pay for things like bridges, hospitals and schools, but the market for the bonds tumbled last year as investors fled to the safest of safe havens, U.S. Treasury securities. The market froze up just as states were issuing record amounts of debt to cover their expenses, throwing state finances into turmoil.
In some cases, new issues were pulled before they got to market. Even wealthy investors who tend to snap up munis for their tax advantages got skittish. In part, this reflected the implosion of the insurance used to guarantee the bonds against default, a victim of last year’s credit crisis.
Since then the federal government has extended a hand through special financing aimed at helping states weather the storm. Washington now subsidizes the interest payments states make to bondholders on Build America Bonds – a new type of taxable bond meant for state and local projects.
Although these bonds are not tax-free, the financial relief they offered to states shored up the muni market as well. The states can offer the bonds and the federal government pays a third of the interest rate as a subsidy to the states.
“Munis really began to recover in expectation of federal assistance – an expectation that proved on the mark,” said Matt Fabian, managing director of Municipal Market Advisors in Westport, Conn., a research firm specializing in municipal finance.
Fidelity New York Income Fund (FTFMX | Get Prospectus
| , for example, a tax-free fund for investors who live in the state, is up 7.17% so far this year. The interest rate the funds pays is about 4%, tax-free. A New Yorker in the 28% tax bracket would have to find a yield of 6.04% on a taxable fund to earn an equivalent amount. |
In comparison, after a tremendous rally in 2008, long-term U.S. Treasury bonds are down more than 13.5% year-to-date. The total return is the bond’s market value plus the interest paid. Yields, which are taxable, are around 3.7% on the benchmark 10-year note, near the highs hit last November.
How much risk?
Still, many investors use funds to diversify muni holdings and spread their risk. Whether muni bonds work for an individual investor depends on a number of factors, including portfolio allocation between stocks and bonds, the investor’s tax bracket, and taste for risk.
In April, Moody’s
| Investors Service issued a negative outlook on the debt of all local governments in the United States. Warren Buffett in his annual shareholder letter also discussed the possibility of municipal defaults. |
“How risky are munis over the long run? Well, you have to be very sensitive to credit quality and focus on the highest-rated issues,” said Evan Rourke, vice president at Eaton Vance Tax Advantaged Bond Strategies. But he, like others, noted that muni defaults are “almost non-existent.”
Individuals can focus on credit quality by buying highly rated bonds or funds wedded to the same goal. Bond funds can spread their holdings to limit the impact of a default by an individual state or local government.
Fidelity’s Pagliocco also noted that fund managers can navigate the shoals to pick up the highest quality bonds. Moody’s statement, he said, “was not a reflection on individual credits.”
After their recent recovery it is unclear whether munis will continue to rally. The federal government’s stimulus probably has put a floor under the market through 2010, the money managers and strategists said. And while the program could be extended, states remain under financial pressure.
“The market still feels more fragile than before the crisis,” said Pagliocco, adding, however, that he does see more stability in munis than during the depths of the market crisis last fall.
