21 July 2019

Is It Too Late to Join the Muni Rally?

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Investing in sewage-treatment plants and highway overpasses isn’t always this consistently lucrative. Municipal bonds have posted gains for 10 consecutive months, the longest rally in state and local government debt since 1992, according to Barclays. Munis, which have a reputation for stability and safety, have returned 8.1% this year, through Thursday, including both price gains and interest payments. That tops the 4.1% return for ultrasafe U.S. Treasurys as well as the 6.4% for highly rated corporate bonds and 4.5% for so-called junk bonds, both of which are seen as riskier investments. Munis aren’t far behind blue-chip stocks. 

Muni investors typically pay no federal tax on the interest—and if they live in the state or city that issued the bonds, they can often avoid those taxes, too. That makes helping governments build vital infrastructure all the more attractive. Investors have responded to the rally by pouring $18.2 billion into muni-bond funds through October, according to Lipper, which tracks fund flows. By comparison, investors yanked $48.4 billion out of munis over the same period last year. Muni bonds lost 2.55% in 2013. But as with any investment, there are risks and other issues to consider before jumping in. 

Here’s what you need to know about making money and staying safe in the $3.7 trillion muni-bond market. 

Are Muni Bonds for You? 

Munis make the most sense for investors who pay a lot in taxes and can use the bonds to lower their tax bill, says Rob Williams, director of income planning at the Schwab Center for Financial Research at brokerage firm Charles Schwab.  In fact, even though munis typically have lower yields than Treasurys or corporate bonds, they may provide more income once you take the tax advantages into account. Many of the issuers also carry strong credit ratings. 

The higher the tax rate, the better munis can look. The advantages can be even greater when state and local taxes come into play.  Investors can use online calculators to help with the comparison. 

Which Munis Should You Buy? 

The seeds of the current rally were sown in the recession and fed by fears over Detroit and Puerto Rico that have festered in recent years as other jurisdictions such as Stockton, Calif., and Jefferson County, Ala., sought protection from creditors in bankruptcy.

The debt problems made investors wary of muni bonds and officials wary of issuing them, which has curtailed supply. This year, however, demand bounced back. In October, when turmoil in the stock market sent many investors fleeing for cover, yields on muni bonds dipped below 2% for the first time in two years. Yields fall as prices rise. Investors, therefore, may be tempted to seek out higher-yielding munis, which often means buying riskier debt or bonds that won’t be paid off for a long time. Instead, investors should be patient and look for short-term muni-bond funds, whose holdings typically mature in less than five years.

If you buy a bond with a decent yield from a reliable issuer, current prices shouldn’t be too much of a deterrent. Even though munis are generally paying a smaller premium than usual compared with Treasurys, a small advantage remains.

Funds or Individual Bonds? 

Brokers often mark up the price of municipal bonds they sell to individual investors, and those markups can be substantial—and hard to identify. The markups that funds pay tend to be much lower, because fund companies buy in bulk and know the market.

As a result, muni-bond funds make more sense for most people. Minimizing fees is “absolutely crucial” to maximizing gains from a low-yielding asset like a municipal bond, she says. Funds also spread the risk by holding bonds from many different issuers. That’s important because the incentives built into muni bonds can encourage investors to concentrate their risk

Buying bonds from your home state often provides the biggest tax breaks, but it also ties your bond investments to the same economy that supports your job and the market for your home. As a result, buying a low-fee muni-bond fund that holds bonds issued by a variety of state and local governments. But be aware that owning a nationally diversified fund can somewhat limit the tax benefits, because fund investors typically only get a break on state and local taxes on the portion of bonds that come from their home state. 

What Are the Risks? 

Even if you buy a fund, don’t dismiss the risk of default. As yields have dropped, investors have pushed into riskier debt, including bonds backed by payments from tobacco companies to states—bonds whose payments are linked to the number of smokers, and could therefore default as smoking declines.

Be careful not to take on too much municipal debt. Muni bonds make up about 10% of the bond market, but comprise closer to 90% of many investors’ bond portfolios. Whether you buy funds or individual bonds, don’t expect this year’s rally to continue forever. At the same time, don’t get spooked if prices fall. 

Click here to access the full article on The Wall Street Journal. 

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