Municipal Bonds Are Volatile but You Can Cut the Risk
Bob Dolan loves municipal bonds and their exemption from federal tax. But the Redwood City, Calif., executive--like thousands of other investors--took a bath last April and May when muni prices plummeted as much as 15% due to rising interest rates.
“I think the volatility of munis is a much bigger issue than their tax significance,” Dolan said. “Municipal bonds can be almost as volatile, if not more volatile, than stocks.”
Dolan knows that recent sharp moves in interest rates, along with tax reform and changes in investor buying patterns, have made investing in municipal bonds riskier and more complicated.
The risks of losing part of your capital are higher these days, many experts contend, because the economy has shifted from a five-year period of declining interest rates, which boosted bond prices, to a period of rising rates, which hurts bond prices. Indeed, many bond investors have lost money since April as rising interest rates resulted in declines in bond prices that more than offset gains from interest payments.
Meanwhile, although tax reform retained municipal bonds as one of the few legitimate tax shelters, it also imposed new rules and restrictions on municipalities that have sharply reduced the supply of new issues hitting the market.
That has increased volatility among remaining bonds while also forcing a shakeout among municipal bond dealers. This week, Salomon Bros., the industry’s top underwriter, announced that it will withdraw from the business while another dealer, Kidder, Peabody & Co., said it would cut back its municipal bond business. New rules also have prompted some municipalities to add new features to their bonds, increasing their complexity.
Tax reform also added complexity by creating three classes of municipal bonds that differ in the way they are taxed. One type, which generally funds government facilities, universities and hospitals, continues to be fully exempt from federal tax. But some bonds, including some that finance sports stadiums and convention centers, are no longer exempt. Other types of bonds, such as certain industrial development, housing and student-loan bonds issued after Aug. 7, 1986, are no longer tax-exempt for taxpayers subject to the alternative minimum tax, a levy generally imposed on taxpayers with large deductions to ensure that they pay at least some tax. The resulting three-tier market in munis requires that investors make sure they understand the tax treatment on their bonds.
Tax reform also increased bond volatility by eliminating some tax breaks for banks and insurance companies that had made them major bond buyers in the past, stabilizing market prices.
Perhaps most important in boosting muni bond volatility have been changes in investor behavior. Investors traditionally bought bonds directly and held them for long periods or until maturity.
But with the growing complexity of the market, investors are increasingly buying munis through mutual funds. Investors in mutual funds are more inclined to sell more frequently, since unloading fund shares is easier than selling individual bonds. Also, mutual funds tend to buy and sell bonds in their portfolios more frequently than individuals, further adding to price fluctuations.
Meanwhile, yields on munis are not as attractive relative to taxable bonds as they were last year. At one point last year, as uncertainty about tax reform caused demand for munis to plummet, the bonds actually yielded more than comparable taxable Treasury securities. But now, long-term municipals with maturities of 20 to 30 years yield about 85% of comparable Treasury bonds, says Richard A. Ciccarone, vice president of research at the investment firm of Van Kampen Merritt.
Despite these and other drawbacks, munis still can be a good investment for taxpayers in the top 38.5% tax bracket this year and top 33% bracket next year. For those taxpayers, the yield on tax-free bonds compares quite favorably to the after-tax yield on taxable bonds, as the accompanying chart shows.
Here are some tips on how to cope with the increased complexity and risks of bond investing:
- Before investing, determine what tax bracket you will be in and if you will be subject to the alternative minimum tax.
Knowing your tax bracket will help you determine whether municipal bonds are right for you. If you are in the 15% bracket this year or next, munis won’t make sense for you. (To help you determine your bracket for this year, see accompanying chart.)
And if you have high income or large deductions that might subject you to the alternative minimum tax, be careful to avoid bonds that are not tax-free under the AMT.
However, if you are not subject to the AMT, those bonds might be a good deal. They yield slightly more than fully tax-exempt issues, although they also carry more risk because their interest payments come from industrial development projects, student loans or other private sources that aren’t as safe as municipalities.
They also are less liquid because they are relatively new and in small supply.
If you are not sure about your tax status, consult with an accountant or other tax expert.
- Consider municipal bond mutual funds, particularly if you don’t have a lot of money to invest. You can invest in many bond funds with as little as $1,000, as opposed to a $5,000 minimum for many individual bonds.
With mutual funds you get diversification and professional management. You also get increased liquidity, because many funds let you withdraw or transfer your money with a phone call.
If you want to save on state and local taxes as well, consider funds that invest solely in California tax-exempt bonds. However, to compensate for their exemptions from state, local and federal tax, they typically yield less than funds investing in bonds from many states.
You also can boost your yield by investing in funds with bonds that are not tax-exempt under the AMT, said Ralph G. Norton, editor of Muni Bond Fund Report, a Huntington Beach newsletter. One such fund is Fidelity Aggressive Tax-Free, Norton said.
Another alternative to mutual funds are unit investment trusts, which invest in a fixed portfolio of issues. Shares in them also can be bought for as little as $1,000.
- Don’t blindly chase the highest-yielding bonds or bond funds. Higher-yielding bonds tend to carry longer maturities, which have higher risks of loss in principal should interest rates rise. Higher-yielding bonds also tend to be considered less safe by the major bond rating agencies, such as Moody’s and Standard & Poor’s.
“You don’t get high yields for free,” Norton said.
If you want steady income with less risk, invest in bonds or bond funds with maturities of less than five years or so, Norton advised. The shortest maturity funds are tax-exempt money-market funds, which yield between 4% and 5% but have virtually no risk of principal loss.
Another alternative: Spread your money into different funds with different maturities, suggests James S. Riepe, director of the mutual funds division of T. Rowe Price Associates, a fund company based in Baltimore. That way you hedge your risk while also leaving open the possibility of profiting should interest rates fall and bond prices rise, Riepe said.
- Interview several brokers before picking one to execute your individual bond purchases. With the complexity of the market, make sure your broker knows what he or she is doing.
Shopping around also helps you minimize commissions, which brokers typically charge through the spread between the selling price and the price they will buy the bond back from you.
Some brokers charge spreads as high as 5% on munis, while others charge as little as 0.1%, says Jay Goldinger, a broker with the Beverly Hills firm of Cantor, Fitzgerald & Co. “Play one broker against another,” Goldinger advised.
- Consider floating-rate municipals. These are munis in which the interest rate is adjusted periodically, usually weekly, biweekly or monthly. The advantage of such bonds is that you can sell them at those given intervals at face value, so there is virtually no principal risk.
The drawback is that you can’t lock in a high yield with such bonds. But AAA-rated “floaters” with rates adjusted weekly are currently yielding about 5.5%, a good buy with the tax exemption, Goldinger said.
HOW MUNICIPAL BOND YIELDS COMPARE WITH TAXABLE BOND YIELDS
A TAX-EXEMPT BOND YIELDING: 4% 5% 6% 7% 8% 9% 10%
IS EQUAL TO A TAXABLE BOND YIELDING: 1987 TAX BRACKETS 11.0% 4.5% 5.6% 6.7% 7.9% 9.0% 10.1% 11.2% 15.0 4.7 5.9 7.1 8.2 9.4 10.6 11.8 28.0 5.6 6.9 8.3 9.7 11.1 12.5 13.9 35.0 6.1 7.7 9.2 10.8 12.3 13.8 15.4 38.5 6.5 8.1 9.8 11.4 13.0 14.6 16.3
WHICH TAX BRACKET WILL YOU BE IN?
TAXABLE INCOME IF TAXABLE INCOME IF 1987 MARRIED FILING JOINTLY SINGLE BRACKET Zero - $3,000 Zero - $1,800 11.0% $3,001 - $28,000 $1,801 - $16,800 15.0 $28,001 - $45,000 $16,801 - $27,000 28.0 $45,001 - $90,000 $27,001 - $54,000 35.0 $90,001 and above $54,001 and above 38.5
