Municipal bonds — often referred to as muni bonds — have a lot going for them right now. In addition to providing an income stream free from federal and, in some cases, state and local taxes, municipal bonds also offer a high degree of safety in terms of interest payments and repayment of principal. Northern Trust’s Tim McGregor and John Skjervem explain why, as the credit markets begin to return to normal, munis might be a good investment option right now.
Q. Muni bonds didn’t fare so well in 2008, with yields soaring as high as 6% on AAA-rated paper. What happened?
McGregor: Several events last year came together to leave muni bond yields at elevated levels. First, many state and local issuers struggled to get short-term financing through their normal channel — what’s known as the auctionrate securities market. They worked around this problem by issuing longer maturity bonds. But this caused a bulge in supply and pushed yields higher. This was compounded by hedge funds selling off large quantities of municipal bonds to meet the deleveraging demands they faced.
At the same time, the monoline insurance companies that guarantee municipal bonds suffered credit downgrades as a result of the credit crisis. This effectively increased the risk for bondholders, which pushed bond prices even lower and tax-exempt yields higher.
Q. What has changed to make municipal bonds more attractive today?
McGregor: First, the auction-rate securities market is gradually being restructured. This is resolving the problem for municipalities — the issuers — of obtaining short-term credit, and should alleviate the need for them to issue longer-term bonds for financing. The restructuring work for hedge funds also largely has passed, meaning the funds are no longer dumping their bond holdings into the market. All things being equal, lower supply means higher prices.
Tim McGregor is the director of municipal fixed income management at Northern Trust, and a portfolio manager for the Northern Tax Exempt Fund and Northern Intermediate Tax Exempt Fund as well as individual accounts. Tim received his B.A. degree in economics from Indiana University, and is a member of the CFA Institute and the Investment Analysts Society of Chicago.
John Skjervem is chief investment officer for Personal Financial Services at Northern Trust. Prior to his current role, John served in Los Angeles as chief investment officer for the western region. John earned his MBA from the University of Chicago and holds a CFA designation with membership in both the Chicago and the Los Angeles CFA societies.
Skjervem: Also, at the margin, there will continue to be a scarcity value for the dependability of an income stream in an environment where bank stock dividends have been eliminated, preferred stocks have been crushed, and a lot of the traditional income sources that clients relied on have been impaired or disappeared. All of this only increases the attractiveness of a well-diversified, high-quality municipal bond portfolio.
Q. Are municipal bonds more attractive to certain types of investors than others?
McGregor: Because they’re so inexpensive from a valuation standpoint — compared to taxable bonds — they’re very effective for almost any taxpayer. And if income tax rates increase — as appears more likely — investors in tax-exempt bonds may see an even better taxable-equivalent yield.
And because of the low level of credit risk, municipal bonds can be attractive to people in a much broader range of income tax brackets. In the past, someone in the 15% or 25% tax bracket probably hadn’t considered investing in munis. But in the current credit environment, munis have become attractive to a much wider audience.
Skjervem: Obviously, the amount of your portfolio that should be invested in municipal bonds will depend on your investment objectives. But we feel strongly that both growthand income-oriented investors can benefit from a well-diversified, high-quality municipal bond portfolio as part of their overall investment strategy.
Q. What types of muni bonds would you recommend?
McGregor: We’d recommend the essential service revenue bonds, such as water, sewer, public power and transportation bonds. We also favor unlimited tax general obligation bonds that are backed by the taxing power of the state and local government. In an unstable economy, the revenue streams behind project-specific bonds — like those to fund a sports stadium or an airport, for example — are too easily compromised. But regardless of a bond’s maturity, we’d strongly recommend trying to buy top-rated (AAA or AA), noncallable bonds. That is, try to avoid bonds that allow the issuer to buy them back if interest rates fall, in which case you’d have to reinvest at lower yields. That said, which specific bonds you want depends on what the prices and yields are, so don’t be locked into just one strategy.
Q. What are the risks of investing in municipal bonds?
Skjervem: There’s always a downside to fixed income: If inflation heats up, it’s bad for bondholders. So munis aren’t a place to hide from that risk. Also, there is a risk that the recession could hurt government revenues, although investment- grade municipal bonds have a strong credit history, one that’s much better than the corporate sector.
McGregor: The math is very compelling for municipal bonds right now. If a AAA-rated municipal bond yields 4%, that’s equivalent to a nearly 6% yield for a taxable security (if you’re in the 28% tax bracket). For that reason alone, investing in municipal bonds certainly warrants some consideration.
The Good Side of Inefficient
We don’t normally consider the word “inefficient” to be positive, but if you’re searching for effective ways to manage portfolio risk and maximize income while keeping an eye on potential tax exposure, inefficient may be what you’re searching for. Our new paper, “Taking Advantage of an Inefficient Municipal Market,” discusses the confluence of events that have created some unique conditions in the municipal bond market and the potential opportunities that exist. To order a copy, contact your relationship manager, or go to northerntrust.com/ourexperts.
