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The risks and rewards of high-yield municipal bonds

Amid low interest rates, clients looking for a tax break and more income may be tempted to consider high-yield municipal bonds.

The yield for a 10-year muni bond rated BAA was 3.27% as of Aug. 10, and yields for 10-year-plus BBB-rated munis were well past 4%. The bonds are exempt from federal, local and state taxes, pushing the effective yield higher for investors in upper tax brackets.

Although high-yield munis may be the right move for some clients, advisors should help them carefully weigh the benefits and risks before taking the plunge.

“High-yield munis can play a role in a diversified portfolio for those investors who are in higher tax brackets,” says Chris Zaccarelli, chief investment officer at Independent Advisor Alliance in Charlotte, North Carolina.

Gregory Hahn, CIO and president at Winthrop Capital Management in Indianapolis, agrees, but cautions that advisory clients look before they leap.

"Municipal bonds are one of the safest fixed-income investments you can make, but when a bond trades cheap, it trades cheap for a reason,” he says. “So, it's important to understand what that reason is."

Advisory clients should know where the revenue from a high-yield muni bond is coming from, bond experts say.

“Is the tax revenue going to be enough to support the project?” Hahn asks.

Bonds backed by a dedicated revenue stream, such as bridge tolls, parking authorities, sewers or water are often viewed more favorably than general obligation bonds coming from municipalities relying on anticipated revenue from budgets, he says.

“Tax revenue from multiple sources is a red flag,” Hahn says.

What's more, municipalities may not get the revenue they intended, and budgets may not get approved or renewed annually, bond experts say.

Advisors should also make sure that clients considering high-yield munis carefully research bonds backed by projects such as hotels, nursing homes or sports stadiums.

Factors to consider include demand for the service, local demographics, management's track record and whether the project is part of a national chain or a local one-off, bond experts say.

Another caveat: high-yield muni bonds are unlikely to be insured. And even if they are, the underlying risk is not completely mitigated, Hahn says.

Zaccarelli cautions advisors to be wary of private-activity bonds, which are subject to the alternative minimum tax.

“These bonds may be federal- and state tax-free, assuming you are taxed in the state that issued the bonds, but they are still counted as taxable income for AMT purposes,” he says. “While this only applies to those taxpayers in higher tax brackets who are subject to the AMT, they are the ones most often looking for municipal-bond income.”

The high-yield muni market was jolted by the Puerto Rico debt crisis this year, when ripple effects from the biggest muni bankruptcy in U. S. history shook investor confidence in lower-rated bonds.

Especially upsetting was a judicial ruling that issuers of several Puerto Rican special revenue bonds under Chapter 9 bankruptcy protection were not required to continue paying bond holders.

In a report issued by Franklin Templeton Investments, “Fundamental Changes That No Muni Investor Should Ignore,” the company said that as a result of Puerto Rico's default, it would not purchase “general fund appropriation debt from cities, counties or states that in our view are facing unsustainable structural budget situations.”

Specifically, Franklin Templeton said that it divested its holdings in bonds from Chicago public schools, the city of Chicago and the state of Illinois.

The market has since recovered, but a number of investors, including Zaccarelli, remain wary of Puerto Rican bonds.

“Personally, I would avoid Puerto Rico, as that is more of a distressed situation and not just a notch or two below investment-grade,” he says. “However, other high-yield municipal bond opportunities, such as those from Illinois or Connecticut, are likely to work out better."

Hahn is bullish on a taxable high-yield bond issued by the Casino Reinvestment Development District of Atlantic City (New Jersey), backed by the Hard Rock Casino. Rated BB by Standard & Poor's, the bond yields 5.46% and is due in 2025.

“Because of the downturn in Atlantic City gaming over the past 10 years, revenue, including sales tax, liquor and gaming are down sharply, and the city was close to bankruptcy,” Hahn says.

“The Hard Rock Casino just opened in the old Taj Mahal, and Atlantic City is going through a resurgence,” he says. “This issue is backed by parking revenue and trades around par, offering a good relative value for investors.”

This story is part of a 30-30 series on tax-advantaged investing.

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