(Corrects explanation of tax treatment of Treasury bonds in 8th
paragraph, to show exempt from state taxes, not federal)
By Linda Stern
NEW YORK Dec 18 I'm a contrarian. So when I see
investors fleeing municipal bond mutual funds at a record pace,
and when I hear that it is nothing but risk, risk, risk for
munis, I start looking for that silver lining.
After all, the secret of successful investing is to "buy
when there's blood on the street," as Baron Rothschild liked to
Certainly, tax-exempt municipal bond funds are bloodied.
They gave up $35 billion in net outflows in the third quarter of
the year - and cashed out another $1.9 billion in net
investments last week alone, according to figures from Lipper, a
Thomson Reuters company.
Fleeing investors have had good reasons to run. For
starters, they have lost money this year. Long-term muni funds
have shed 4.47 percent of their investors' money in the year to
date through Dec. 16.
So, some investors are just taking their money out and
investing in stocks instead - that 25 percent return recorded so
far by the Standard & Poor's 500 stock index is hard to ignore.
Others are selling to take capital losses they can use to offset
Then, there are all those risks: With Detroit declaring
bankruptcy and Puerto Rico gathering troubles and downgrades,
investors worry that they could lose the money they put into
these bonds. The idea that the Federal Reserve will allow
interest rates to rise has investors stepping back from all
kinds of long-term bonds: If rates rise, the value of the bonds
they are holding will fall.
Heap on the possibility that Congress will devalue the tax
benefits accorded munis when it finally does some kind of tax
reform, and it is no wonder the whole market has been a big
On the other hand, the overall economic health of state and
local governments has been improving, so defaults should become
less of a worry. And the interest on muni bonds - exempt from
federal income tax and sometimes, from state income tax too - is
tasty. Right now you can buy top-rated AAA 10-year munis
yielding 2.7 percent - the equivalent of a 3.9 percent taxable
yield if you're in the 28 percent federal/6 percent state tax
bracket. Treasuries (exempt from state but not federal taxes)
are yielding 2.9 percent for the same maturity.
Other reasons to buy munis?
They don't correlate to stocks, and in the year following a
stock market blow out, you may want that lack of correlation.
Furthermore, munis are less volatile than Treasuries in a
rising rate environment, says specialist Dawn Mangerson, vice
president and senior portfolio manager with McDonnell
Investment, a unit of Natixis Global Asset Management. "Munis
are so cheap," she told reporters at a recent outlook meeting.
Long-term munis with 10 or more years to run on their
maturity now are priced 0.60 percentage points over Treasuries -
the widest spread in 18 months and up from 0.28 percentage
points in mid June, according to Bank of America's Merrill Lynch
Here are some ways to cautiously approach a market that
might be done bleeding soon.
Check your municipal bond holdings for losses; if you've got
any, take them now. Even though the interest on them is
tax-exempt, the gains and losses you record by buying and
selling munis still are subject to capital gains taxes. You can
buy different issues right away - or -if you have a particular
muni fund you like, wait 30 days before you buy it back to avoid
violating tax rules.
DO THE MATH
The more you make - and the higher taxes are in your state -
the better munis are for you. That same 2.6 percent tax-free
yield mentioned above would be worth 5.61 percent a year to a
Californian (tax rate 12.3 percent)in the top 39.6 percent
federal income tax bracket. Furthermore, muni interest also will
not be subject to the new 3.8 percent investment income surtax
hitting any single person who earns over $200,000 (or $250,000
Just as all real estate is local, so are all muni issues.
Some cities and states have large pension liabilities that could
cause them to default on their obligations down the road.
Others are very much in the black. If you're going to be
buying individual issues, "the first thing to look at is
investment quality," says Russell Francis, a fee-only financial
adviser in Portland, Oregon, who specializes in building bond
portfolios for his clients. That means sticking with bonds - or
bond funds - that sport ratings of AA or above.
You can stick with a mutual fund or exchange-traded fund and
let someone else vet the portfolio. If you are buying individual
bonds, dig deeper than the ratings. Read about the issuing
authority and make sure that they aren't overextending on
projects or pensions.
CHOOSE YOUR MATURITY CAREFULLY
Thomas McLaughlin, a municipal bond strategist with UBS
Financial Services Inc., says the sweet spot is in the middle
range. He is concentrating on bonds with between 5 and 15 years
of maturity, on the theory that they will pull in bigger yields
but avoid the extreme volatility of the longest bonds. You can
build a "ladder" of various maturities so that you always have
some money coming in to reinvest, and some longer term bonds
capturing higher rates.
(Editing by Bernadette Baum)