How to Decide if Municipal Bonds Are for You
Like homeowners anxious to refinance mortgages, state, city and county governments are hot to pay off high-rate debts with money borrowed at today’s low rates.
As a result, bond experts think that July could be the biggest in history for municipal bond “calls.” That’s when state, city and county governments call in their bonds to pay them off early.
About $8 billion in bonds are expected to mature or be called on July 1, according to James J. Cooner, senior vice president at Bank of New York. Another $2 billion could be paid off during the rest of the month.
And that’s likely to leave thousands of investors with billions of dollars and nowhere to go.
Sure, you can jump right back into the municipal market. But you’re unlikely to find the relatively high rates you enjoyed before. Indeed, some predict that the flood of “call cash” will create a seller’s market for high-quality municipal bonds--pushing up prices and depressing already anemic yields.
Municipal bonds that yield more are likely to bear significantly higher risks. High-yield municipal bonds will be issued by public agencies that have little financial backing and questionable prospects for repayment, some experts say.
What’s a bondholder to do?
Before hopping back into the market, consider whether municipal bonds are still for you.
These bonds have one main attraction: Tax benefits. Those who buy bonds issued by their resident states usually enjoy earnings that are exempt from both state and federal taxes--sometimes local taxes as well. If you’re in the highest federal tax bracket and live in a high-tax state, that’s a powerful incentive.
For a high-income Californian or New Yorker, for example, the yield on a 5% municipal bond is equivalent to about 8% on a fully taxable bond.
But the return is significantly less for those in lower tax brackets.
Individuals who have retired or otherwise seen a decline in taxable income during the year should consider whether municipal bonds remain appealing. Additionally, those who live in states with low or no income tax might also do better in other segments of the bond market. (That same 5% muni bond has a taxable-equivalent yield of around 7.25% in Texas, Florida, Washington and Wyoming.)
You might also want to steer clear of munis if you might need to sell prior to maturity, experts say. That’s because interest rates will likely start climbing over the next few years, and that will make it harder to sell a bond without sacrificing some of your principal. Remember, bond prices fall when interest rates rise and vice versa.
When interest rates shot up during the late 1970s and early 1980s, for example, some municipals were selling at discounts of up to 50% of their face value, said Stuart Kessler, senior partner at Goldstein, Golub, Kessler & Co. in New York. In other words, a $10,000 bond sold for $5,000 in cash.
Lastly, investors looking for shorter maturities should look carefully at taxable equivalent yields, said Cooner. Right now, municipals with maturities between one and four years aren’t paying much more than similar Treasury obligations. In such cases, the Treasury is usually a better buy; it’s easier to sell and secured by the U.S. government.
If you still want munis, here are some tips:
* Stick with medium-term obligations--those that pay off within five to seven years, said Cooner. Rates on longer-term bonds aren’t rich enough to risk tying up money for a longer stretch.
* Stagger maturities, said Kessler. Buy some bonds that pay off soon, some later. That provides protection against interest rate risk because investors can reinvest proceeds from short-maturity bonds into higher-rate options if interest rates start to rise.
* Buy quality. The recession has ravaged the finances of many state and local governments, which has made the muni market riskier than it’s been in years. Look for bonds that have A- to AAA-ratings from both Moody’s and Standard & Poor’s.
* Check the repayment source. General obligation bonds are often considered safer than revenue bonds. But that’s not always true. A revenue bond backed by a necessary public agency or utility--a water district, for example--can be as safe or safer than a general obligation bond, which is supported by tax revenues. But revenue bonds issued by non-essential operations, such as theaters, parking lots and golf courses, may be dangerous, Cooner said.
* Consider two yields. Bond buyers almost always know how much their bond will yield to maturity, but in today’s market, they should also know what their yield would be if the bond was called at the first opportunity. If the yield to maturity is 6%, but the yield to the first call date is 5%, investors should assume it’s a 5% bond. Said Cooner: “You should assume that the bond is going to be called.”
