After years of TINA, or “there is no alternative” to stocks, bonds are back in the spotlight. The bond sell-off this year has pushed prices down and yields up, making municipal bonds an attractive place to seek income, especially for high-income investors in states with high marginal tax rates. But there’s more to the asset class than tax-free benefits. Municipal bonds, or munis, have outperformed other bonds this year, but have fallen again. The Bloomberg US Aggregate Total Return Index, a basket of different types of bonds, is down more than 15% year-to-date, while the Bloomberg Municipal Bond Index is down about 12%. Because yields move inversely to price, this means yields are at their highest in over a decade. “The selloff has created opportunities we’ve hardly seen in 15 years,” said Cooper Howard, fixed income strategist for the Schwab Center for Financial Research. “To be frank, these are exciting times for bonds,” said Megan Gorman, founder and managing partner of Checkers Financial Management in San Francisco. 1. Consider Equivalent Tax Yield Muni are tax exempt at the federal level and at the local and state level for residents of the issuing state. This means that a taxable bond would have to earn a higher yield – and potentially face higher risk – to match the yield of the municipal bond. For example, those subject to the top federal tax rate of 37% can earn a similar tax-equivalent yield from a 5% municipal bond and an 8% high-yield corporate bond. Since a corporate bond with such a high yield is usually rated rotten, muni is a much safer bet for the same income. But that doesn’t mean investors should only buy munis in their home state to reap double or triple tax-free income. Investors in states that have high taxes and issue many munis, such as California and New York, may be able to focus on state bonds and enjoy several levels of tax advantages. But investors outside of those states may find it difficult to invest solely in the state while maintaining a diversified bond portfolio, according to Howard. “We suggest that if you invest in municipal bonds, individual bonds, you invest in 10 different issues with different credit risks,” he said. “It could be relatively difficult in one state.” This means that most portfolios should include a mix of state municipalities beyond an investor’s original residence. A balance of 75% to 80% from in-state municipalities and the rest out-of-state typically works, said Scott Sprauer of MacKay Municipal Managers. Also, while investing in-state means no taxes, you can get higher returns or at least an equivalent return by acquiring an out-of-state muni. This is because of the tax equivalent yield, which is the yield that a muni or other bond gives after paying taxes. 2. Credit ratings still matter Although muni yields have jumped, it’s also vital for investors to look at each bond’s credit rating and not simply seek out the highest yields. As with other bonds, those with lower credit ratings carry an increased risk of default by the issuer. “Getting your money back is” key, said John Luke Tyner, bond portfolio manager at Aptus Capital Advisors in Fairhope, Alabama. It’s also a good idea to think about why the bonds are issued, as some projects are safer than others. For example, schools are generally a safe bet because they are funded by taxes. Hospitals and utilities like water and sewer are essential and are therefore probably safer municipal investments than sports stadiums or highways. Other types of munis to look closely at are private, state-backed projects, such as the American Dream Mall in New Jersey or the Brightline Rail project in Florida, which carry a higher risk. But, generally speaking, credit quality in the municipal bond market has been strong over this past cycle. “Part of the reason is the amount of tax relief that was provided to state and local governments right after the coronavirus crisis began,” Howard said. “It was substantial.” Of course, when comparing munis to corporate bonds, there is an important distinction – typically, corporate debt is unsecured, meaning it has no collateral. In contrast, munis are generally secured by local and state revenue, sales, and property tax receipts, making them more secure. It’s also important during a recession, when some companies are more likely to be downgraded quickly, Sprauer said. “It’s less the case in the muni market because it’s very, very stable,” he said. 3. Investing differs from stocks Bonds serve a different purpose in a portfolio than assets such as stocks, which you hope will increase in value over time. For bonds, and in particular munis, investors are not so much looking for returns as they are looking for income, and whether the issuer will make payments on time. “There’s usually some price appreciation with this, but it’s hard to bet on price appreciation unless you’re a very active bond trader,” Tyner said. For retirees, this piece of the puzzle is especially beneficial because they want portfolios that generate income, especially in a year when stocks have fallen in value. “If we look at the traditional retirement planning strategy, you want to have things like Social Security, pensions, dividend income, and you want a bond interest layer as well,” Gorman said. “And if it’s interest on tax-exempt bonds, even better.” Because municipal bonds are so complicated and there are nuances in every investor’s portfolio, experts generally recommend relying on a bond fund manager or working with a financial advisor or other expert to determine what to buy. Diversified bond mutual funds are also a good option for investors, providing access to the muni market without having to take the risk of buying individual bonds. See below for a list of municipal bond funds:
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