By John Wasik
CHICAGO Jan 18There 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
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
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
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
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
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
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.