CHICAGO (Reuters) - There is a bubble forming in the municipal bond market, and millions of investors could be impacted if it bursts.
In the coming months, as Congress and the White House wrestle over the next budget, debt ceiling and new sources of revenue, volatility is likely to roil the muni market. Skittish investors had triggered a minor sell-off in December. Yet despite a 1.2-percent loss in the last month, the Barclays Municipal Bond Index gained 6.8 percent overall in 2012.
Munis avoided the chopping block in the last round of fiscal cliff negotiations, but that does not mean they are in the clear. They are still vulnerable in the debt-ceiling negotiations since Washington is looking for new sources of revenue to reduce the federal deficit. No matter how Congress acts, you still need to be cautious. Any uptick in interest rates, or market hiccups, could trigger losses, too.
Although it is unlikely that Congress will raise marginal federal rates further, the Obama Administration has proposed capping the muni-bond tax break at 28 percent of income. If it comes to pass, paring the deduction would be the first time Congress trimmed the tax exemption. At present, munis cost the U.S. Treasury some $40 billion annually.
In 2012, municipal bonds finished a two-year run with a 20-percent gain, according to Bank of America Merrill Lynch. No wonder investors have been exuberant during the past year, piling into the bonds directly and into the exchange-traded funds that hold them. More than $54 billion flowed into muni bond funds in 2012 alone.
As the year-end 'fiscal cliff' approached, these funds drew more than $5 billion a month on average from July through November. Since the start of the 2013, muni funds have grabbed more than $2.4 billion, according to Lipper, a unit of Thomson Reuters.
When you consider that muni funds took in only about $13 billion in all of 2011, the flood of money shows how much investors - particularly high net-worth individuals - believed their tax rates would climb as a result of fiscal cliff talks. The most affluent among them were right: Marginal federal tax rates rose for those earning more than $450,000.
The rapid inflows have boosted prices during a time of low yields, but that's always a good thing. There is bound to be another storm ahead as markets react to the partisan bickering.
Here are five red flags to heed:
1. BE CAREFUL WITH BUILD AMERICA BONDS
These special-issue government bonds are on the red-flag list of Stan and Hildy Richelson, bond specialists who are money managers at Scarsdale Investment Group in Blue Bell, Pennsylvania. They were issued by the federal government as part of the 2009 stimulus plan to fund job-creating capital projects and infrastructure.
The federal government may reduce the amount of tax credit paid to states, which "might reduce prices and/or result in an early call," the Richelsons said jointly in an emailed interview.
If you're willing to take the risk of these bonds getting call before they mature, the yields could be attractive.
2. TAXABLE MUNIS ARE SENSITIVE
Similar to tax-exempt munis, taxable muni bonds may finance investor-led housing, sports facilities or underfunded pension plans.
A market sell-off could hurt these bonds, which "could lose a quick 10 percent to 15 percent," the Richelsons say.
However, buy-and-hold investors "may get better cash flow and a better underlying quality, making the return of principal more likely," they add.
3. BE WARY OF SPECIALIZED ISSUES
Proceed with caution before you buy munis with references to "structured," or "appropriation," along with any bonds issued by states in fiscal trouble like Illinois or California.
"If the issue is not backed by the full faith and credit of a sound issuer or a substantial revenue source, there is a risk that the bond may not be paid off at its due date," the Richelsons warn.
Are you holding the highest-rated bonds with solid issuers? Don't sweat it. Higher rates aren't always a bad thing.
"We believe that the most important aspect of bonds is cash flow and rising rates create more cash flow," they say.
4. AIM FOR THE TOP-RATED
"We are not recommending muni funds as there are still too many communities that are in deep financial stress," advises Sid Blum, a financial planner with GreatLight Fee-Only Advisors in Evanston, Illinois. "If a client had to have a muni, I would only look at AAA-rated bonds."
General obligation bonds typically are seen as being safer than "revenue" bonds. The former are funded by fees and taxes - which can be raised - and the latter from the income of a specific project.
5. WATCH POLITICAL RISK
Although it is devilish to quantify, you also need to keep an eye on political risk involving taxes and the financial state of the issuers. The best way to dampen that kind of volatility is to hold a diversified portfolio of bonds or bond funds that span the gamut from mortgage agencies to short-term treasuries.
If you want to deal with the risks of the muni market, alternatives to buying and holding top-rated bonds include several exchange-traded funds.
The iShares National AMT-Free Muni Bond fund, holds more than 75 percent of its portfolio in AA and A-rated bonds and yields almost 3 percent. It returned 5 percent last year.
An alternative is the SPDR Nuveen Barclays Capital Muni Bond ETF (TFI.P), which has roughly the same yield but gained 6 percent last year.
(The author is a Reuters columnist. The opinions expressed are his own.)