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Unlike the interest on Treasuries, which is taxable at the federal level, the interest on municipal bonds is tax exempt for in-state residents at the federal, state and local levels. For example, a New York state resident who buys any bond issued by New York state or any of its governmental entities, such as towns or school districts, would not have to pay federal, state or local taxes on the income earned from the bond. Municipal bonds usually pay interest semiannually.
No matter how they use munis, most planners agree that the primary concern with muni investing is, "Don't make a mistake," says Matthew Chope, a partner in the Center for Financial Planning in Southfield, Mich. An investor must have at least $100,000 to warrant investing in individual bonds, since at least four different types of bonds are needed for diversity at a typical purchase of $25,000 each. (Municipal bonds come in increments of $5,000.) With smaller amounts, a bond fund is the way to go.
Muni prices are often quoted in comparison with Treasuries. The closer munis come to 100% of Treasury bonds, the cheaper they are. In recent years, intermediate- and long-term municipal bonds typically have traded at 85% to 95% of Treasuries.
They were a screaming buy last summer--long-term yields were 102% of government bonds. At that level, investors receive the bonus of extra yield on top of the tax-free interest.
This year, however, the percentage is dropping to about 80% to 90%, signaling a decline in the relative value of munis compared with Treasuries. So bond traders would be more likely to be selling munis and buying Treasuries. This consideration affects mainly those who want to trade the two off against one another. It's of little importance to the buy-and-hold investor.
The relatively flat yield curve makes shorter-term taxable bonds a better buy than long-term bonds because investors get the same interest earnings over a shorter maturity range and obtain protection against any future inflation that would reduce the value of longer-term bonds. The yield curve is a bit steeper for munis, so advisers might want to consider longer-term munis. For example, the 30-year Treasury is only yielding about five basis points more than the two-year note, while a 30-year muni might yield as much as 100 basis points more than a two-year municipal bond. However, even with munis, there is still less risk with shorter maturities.
Minneapolis-based planner David Dresbach considers interest rate movements when advising clients on bond purchases. He uses a model that analyzes a client's tax bracket and a bond's characteristics and comes up with a "what I get to keep" column that tells clients what they get after taxes on different kinds of securities. With munis at 85% to 90% of Treasuries, "it's pretty hard not to pick munis," he says. Dresbach spent part of his career as a financial adviser to municipalities, helping them issue bonds.
Some planners report that the yield curve has nothing to do with their investment decisions, however. Chope says he would rather focus his decision-making resources on the equity side, where asset allocation moves can have a much bigger impact. With bonds, the spreads aren't big enough at 30 basis points to spend much time analyzing different options.
Lili A. Vasileff, a planner in Woodbridge, Conn., also doesn't vary her muni strategy, but for a different reason. Her clients are mostly divorced women.
Since they haven't worked and they received a lump-sum divorce settlement instead of monthly alimony, she uses munis to provide them with a steady stream of income while protecting their assets from tax consequences. For those middle-income women who do receive alimony, she finds munis also useful to augment their alimony payments.
Investment-grade municipal bonds are rated from triple-A, the highest, down to the triple-B range. Below-investment grade ratings descend from double-B.
Today's investors aren't compensated adequately when they invest in minimum investment-grade bonds. For a municipal bond maturing in 10 years, the difference in interest rates between the triple-A bond and a bond rated minimum investment grade is only about 25 basis points. At that spread, it doesn't pay to sacrifice safety for yield, and investors should stick to gilt-edged securities, as triple-A bonds are known. For a municipal bond maturing in 15 years, the spread is about the same. In this type of climate it doesn't pay to buy bonds beyond 10 years or bonds at the lowest investment grade.
DIFFERENT TYPES OF MUNIS
The following five categories of municipal bonds offer both capital preservation and safety. All of the munis described below would have at least double-A credit rating characteristics.
General obligation bonds. Historically, individual investors have preferred general obligation or GO (gee-oh) bonds over other types of municipals because they offer special protection. GO bonds are secured by the full faith and credit of the government body that issues them. Principal and interest payments are secured and payable from virtually all government revenues. Their default rate, at less than 1%, is the lowest of all bond categories. In the unlikely case of default, the bond trustee can sue on behalf of the bondholders to force the municipality to raise taxes enough to cover debt service. The demand for GO bonds often drives up their price, resulting in a lower yield and overall investment value.
Of course, not all government issuers share the same credit qualities, and this is reflected in their underlying ratings. One town issuing bonds might have a booming population and exploding tax revenues, while another suffers job losses and a declining population. Remember the lesson from real estate investing and consider location, location, location when buying municipal bonds.
Dedicated tax revenue bonds. These offer diversification for both issuers and investors. They are most often backed by a personal income or sales tax. A portion of these tax receipts goes first to pay off the bonds, and any remaining funds flow into the seller's general coffers. The dedicated tax revenue base is usually very large--almost everyone pays sales and income tax--and receipts can more than cover the bonds' principal and interest. To further secure the bonds, a debt service reserve fund equal to one year's worth of principal and interest is also pledged to bond repayment. Based on this strong coverage, dedicated sales tax revenue bonds frequently earn higher ratings than GO bonds, while providing slightly higher interest rate payments.
Essential service revenue bonds. These are a type of purpose bond issued by municipal enterprises such as water and sewer utilities. The enterprise usually has the attributes of a monopoly, with no competition in its service area. Essential service revenue bonds are backed by revenues left over after the enterprise pays its operating and maintenance expenses. The bonds receive further security from covenants, or promises, to bondholders that certain rates and fees will be raised if revenues ever fail to cover principal and interest by a required amount. A debt service reserve fund is also pledged to bond repayment. Higher-rated enterprise bonds are very safe municipal investments.
Many types of municipal enterprises do not provide an essential service, however. These enterprises don't always control the revenue stream that backs their bonds and are often lower-rated than essential service bonds.
The backing for hospital revenue bonds, for example, depends largely on revenue from private patients, insurance companies and reimbursement from both the federal and state governments. Some of these revenues, such as Medicare or Medicaid reimbursement, are vulnerable to legislative action. And competition from other health facilities can also affect credit characteristics.
In today's market, lower credit quality does not translate into meaningful higher interest payments. So it's important to evaluate each essential service revenue bond offering to be sure it meets quality, yield and safety criteria for clients.
Agency bonds. These are sold by federal, state and local agencies, and they include federally guaranteed mortgage-backed bonds sold by Ginnie Mae, the Government National Mortgage Association and Freddie Mac. These bonds are taxed at the federal level.
Insured munis. More than half of municipal debt is insured by various bond guarantors. The track record of these guaranty companies has been excellent, and most insured bonds carry a triple-A rating. It's important to view bond insurance as a credit enhancement, not as a stand-alone security feature. In other words, the underlying credit rating of the bonds counts, even when the issuer has bought bond insurance.
Insured bonds with good underlying credit often trade with the same yield as uninsured higher-rated bonds with the same maturity. While part of the reason for this lies in the flatness of the yield curve, more of it is due to supply and demand. Since a large portion of the municipal market is composed of insured bonds, a strong supply effectively lowers the yield difference between unenhanced and insured debt.
THE AMT
When advising clients about municipal bonds, it's important to assess whether the investors could be subject to the alternative minimum tax. Congress originally created the AMT to ensure that high-income taxpayers could not abuse tax shelters and other deductions to avoid all tax liabilities. However, over the years the AMT's reach has extended to affect more middle-income taxpayers.
Most municipal bonds have no bearing on the AMT. However, the income from private activity municipal bonds must be included when calculating a taxpayer's AMT liability. These bonds are issued to finance a project without a purely governmental function. Investors who currently find themselves in the AMT bracket, or who may enter this bracket in the future, should avoid private activity municipal bonds.
Other muni bonds may also have AMT ramifications for investors. Read all the offering documents to determine whether a bond or bond fund is subject to the AMT. Housing bonds are more likely than many other categories of municipal bonds to be subject to the AMT.
In today's market, municipal bonds and bond funds offer a relatively safe investment for your clients, especially those with higher incomes. You can generally increase the yield for your clients without increasing their exposure to lower credits by diversifying with essential service revenue bonds and dedicated tax revenue bonds.
Today, there is also little reason to put a client at the mercy of interest rate and market volatility by buying long maturities, as shorter maturities pay the same yield. Finally, it's a good idea to buy insured municipal bonds that offer greater safety because the cost for that extra security is minimal.
Stuart Bromberg is managing director and head of municipal research at Samuel A. Ramirez & Co., a full-service boutique investment bank based in New York.
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