For many upper-income investors, a shift to bonds means a fresh look at tax-exempt municipal securities.
And some of them are doing a lot more than looking.
“We have been seeing people sell $300,000 to $400,000 of stock in one clip and put it into municipals,” says Alexandra Lebenthal, president of Lebenthal & Co., a New York firm specializing in municipal bonds.
Municipal bonds can be a good fixed-income choice for people in top tax brackets. Someone in the 39.6 percent bracket, for example, would have to find a taxable security with a 9.1 percent annual yield to match what is available tax-free on a long-term municipal bond.
But for people in lower tax brackets, the benefit of tax-exempt munis isn’t so clear in today’s market. With short maturities and money-market funds, people in the 28 percent and even the 31 percent tax brackets may do better with taxable securities.
Then there is the fact that munis today are simply paying less in interest than what typically is required to draw investor attention.
“The rule of thumb in the municipal markets is that investors like to see 6 percent yields,” says James L. Kochan, director of fixed-income asset management at Robert W. Baird & Co., Milwaukee. Investors would need to take on extra credit risk or a very long maturity to get that yield today, he says.
For all of these reasons, investors should do some homework before moving into the municipal market, especially if they have paid little attention to bonds in recent years.
Timing, for example, may be an important consideration. Seasonal factors are waning that have helped keep muni yields low, says Kochan, and that should create “some reasonably good value” toward the end of the first quarter.
By then, the glut of reinvestment money created by January’s bond-coupon payments and bond “calls,” or early redemptions, will have worked its way through the market, he says. Moreover, the supply of new bond issues is expected to increase, reducing the competition for bonds and raising yields.
Another consideration is quality. “There are a lot of places to go for yield, but stepping down in credit quality is not one of them,” says George D. Friedlander, managing director and fixed-income strategist at Smith Barney.
That is because the market currently isn’t differentiating much between the best credits and riskier debt, he says. The yield difference between a triple-A-rated insured bond and a single-A-rated uninsured bond is modest at best. And, should the market get jittery, the top-rated bond would hold its value better.
“This is what happens at the end of credit booms,” explains J. Michael Martin, a Columbia, Md., financial planner. “The market isn’t discriminating among credits. Then late in the cycle, you see a flight to quality.”
Investors also shouldn’t be tempted to eke out extra yield by extending bond maturities to the long end of the market. That is because the yield curve rises most sharply in the early years. The difference between a 10-year bond and a 20-year bond is only about half a percentage point in annual yield, while going out to 30 years brings in only 0.05 additional percentage point.
Moreover, if interest rates fall, bonds with maturities of more than 10 years may be called, leaving the bondholder looking for a new investment.
Rather than choosing a specific maturity, bond experts typically recommend spreading out that risk. By creating a “laddered” portfolio, a portfolio of bonds maturing at regular intervals, investors will have some protection should interest rates rise or should some need for cash develop.
One place investors might find additional yield is in something called “cushion bonds,” says Lebenthal. Issued when interest rates were higher, these bonds may be called in the next five to seven years. They are selling for a premium, which means you won’t get that premium back when they mature, but in return you get between a tenth and a quarter of a percentage point more in yield until then.
When buying municipal bonds, do some comparison shopping. “You should be asking what else is available,” says Jack Ablin, director of fixed-income investments at the Bank of Boston. That means not only comparing various municipal issues but also figuring out if the yield is competitive with what you might get in the taxable market.
To make that comparison, simply divide the tax-exempt yield by your “keep rate,” which is the amount of each dollar Uncle Sam doesn’t get in taxes. Thus, someone in the 28 percent tax bracket would have to get 7.6 percent on a taxable investment to equal a 5.5 percent yield on a long-term muni, while someone in the 31 percent bracket would need to get 7.9 percent.
Common wisdom says that investors with less than $50,000 or $100,000 to invest should steer clear of individual bonds. This avoids the markup that comes with buying and selling small lots.
But people with no intention of selling may do just fine buying bonds in $5,000 and $10,000 pieces. “But if you are buying small pieces, be prepared to hold to maturity,” says the Bank of Boston’s Ablin, noting that the owner of odd lots will pay dearly for selling small pieces of bonds.
Still, buying and holding odd lots can make more sense than using bond mutual funds. That is because much of the attraction of bonds–the guaranteed income and return of principal–disappears once you put it into a fund. Moreover, bond-fund managers have to take more risk to keep their yield high enough to offset fund management fees.
“You are taking additional risk when you buy a muni bond through a fund, and you are not rewarded for that risk,” says Ronald W. Roge, a Centereach, N.Y., financial planner, who typically uses bond funds only when investing in overseas bonds or low-rated “junk” bonds that need broad diversification to reduce risk.
Indeed, risk is the last thing you want in the fixed-income part of your portfolio. “Bonds in general are a low-risk, low-return vehicle, and that is what they are meant to be used for,” says Roge. “Once you start using them for anything but a foundation for a portfolio, you probably want to look at something else.”
