Municipal Bonds Doing Well Despite Weak Economy
Investors in tax-free municipal bond funds have a lot to be thankful for this year.
Interest rates have dropped in 1991, pushing up the values of all bond investments, including tax-free funds. And despite the weak economy, the vast majority of cities, states and local governments haven’t fallen over the edge financially.
“For the most part, disasters involving municipal bankruptcies haven’t happened,” says Zane Mann, publisher of the California Municipal Bond Advisor, a newsletter based in Palm Springs.
This isn’t to say that tax-free bonds are out of the woods yet or that municipalities will have an easy time bouncing back from the recession. But muni bonds in general--and especially those in California--have done well enough during the past year and a half to reaffirm their standing as low-risk investments.
“By and large, munis are very safe,” says Bob Patterson, who runs a California tax-free fund and two other muni bond portfolios for Oppenheimer Management Corp. of New York. “We’re not at all concerned with a default scenario.”
That’s good news for investors lured by tax-free interest. In general, nationally diversified municipal bond funds currently yield 5.5% to 6.5% or so, equivalent to 8% to 9.4% on a taxable investment for someone in the top effective 31% federal bracket.
California muni bond funds, which mostly hold securities issued within the state, offer yields exempt from state and federal taxes for California residents. A 6% yield on one of these funds is equivalent to 9.8% on taxable investments for someone in the top tax bracket, Mann says.
Yields, of course, aren’t everything. If interest rates or defaults rise, municipal bond funds will fall in price. Higher interest rates in 1987, for instance, wiped out the tax-free yields that year. So far in 1991, however, rates have ebbed, and that has pushed up the values of muni bond portfolios.
In terms of default risk, what people sometimes seem to forget is that behind most bonds is either a government with broad taxing powers or a bridge, water system or other project with good revenue-generating potential. Although individual municipal issues can and do sometimes get into trouble, the credit dangers are lessened for people investing in tax-free bonds through a mutual fund.
Most funds hold dozens if not hundreds of individual securities and thus have plenty of diversification. In addition, each fund is run by a professional who’s paid to know which bonds to buy and which to avoid.
In California, for example, so-called Mello-Roos muni bonds rate as one of the riskier categories, says Stephen Adams, managing director of Van Kasper Co., a San Francisco brokerage.
These developer-backed bonds are used to finance infrastructure improvements in new housing tracts. When everything goes smoothly, the improvements are made, homes are built and new residents move into the area and pay taxes to retire the bonds. But if the developer can’t complete construction or sell enough homes, the bonds could go into default.
“This is one of the things you get with a mutual fund: a professional manager who can size up different types of bonds,” Adams says.
As another safeguard, some tax-free funds invest in insured municipal bonds. On insured bonds, all interest payments and the repayment of principal are guaranteed when due. This backing is provided by one of the five big insurance companies that dominate the market. Because of the added safeguards, insured bonds sell at slightly higher prices and lower yields than would otherwise be the case.
Critics point out that this form of protection is only as strong as the company providing it. Yet bond insurers are well-capitalized, closely regulated outfits that purposely tend not to extend coverage to weaker municipalities, Mann says.
Although a larger percentage of newly issued muni bonds are coming with insurance attached, most bond funds don’t concentrate on this segment of the market. For example, Lipper Analytical Services counts only eight insured California muni bond funds with combined assets of $1.6 billion, compared to 61 noninsured funds counting $25.8 billion in assets.
On mutual funds, Mann believes that insurance generally isn’t worth the sacrifice in yield. “Funds have wide diversification and professional management. I’m satisfied that’s enough safety.”
At the end of October, insured California muni bond funds were yielding 5.85%, compared to 5.92% for California funds in general, reports Lipper.
Keep in mind that insurance protects against default risk, not interest rate fluctuations. As noted, municipal bond prices have appreciated in recent months as interest rates moved lower. But if that trend reverses course, the bonds--and the funds that hold them--will lose value.
The tough part about interest rates is that nobody really knows where they’re headed over the long term. Patterson says he sees flat rates ahead, while Adams predicts the current downward spiral in interest rates could last two to four more years.
Mann, however, fears that interest rates are near a bottom. Although he doesn’t recommend selling muni bond funds, he doesn’t advise adding new money, either. “Interest rates are down to the point where you’re paying high prices for these funds,” he says. “I’m reluctant to buy any funds today.”
A Good Year for Muni Funds
Price gains by an index of 12 leading California muni bond funds so far this year (yields excluded).
Source: California Municipal Bond Advisor newsletter.
