Why Munis Could Lift Your Bond Market BluesAmey Stone
Rising interest rates have hammered fixed-income markets repeatedly this year and may continue to do so for the next few months. But if you aren't spooked by the decline and can handle some volatility, you will find some compelling reasons to buy municipal bonds.
First, yields on long-term munis currently equal about 80% of the yields on taxable Treasury securities. That means anyone above the 15% bracket is better served in tax-frees. If you are subject to state income tax you can get double tax-exemption by buying your state's bonds. For people with a marginal tax rate of 40%, the aftertax yield on a 20-year bond is about 10%. "That's about the same or a little greater than the average annual total return on the Dow Jones industrial average for the last 65 years--without the risk," says Robert Goodman, chief economist for Putnam Investments.
Add low inflation to the equation, and munis are looking even better. Tax-free yields are now around 6.5% for high-grade, long-term munis maturing in 20 years or more. Subtract this year's 2.7% increase in the consumer price index and you're getting nearly a 4% real return. "These real rates are higher than they were in 1981, when you had market yields of 14% and 15% on tax-free bonds and inflation of 12% or 13%," says Goodman.
That 4% real yield is an anomaly. So if inflation stays moderate, muni yields should drop--as much as a full percentage point, predicts Jay Chitnis, a bond dealer at Stoever Glass in New York. Then, people who hold today's high-yielding bonds will see them surge in price.
All these pluses are buoyed by the fact that the muni-bond supply has fallen off dramatically since February. In 1993, municipalities rushed to refinance and issued a record $300 million in bonds. So far this year, new munis are being floated at a rate 60% lower than last year, says Joseph Deane, portfolio manager of Smith Barney Shearson Managed Municipals Fund. That will give municipal bonds some downside protection if rates continue to rise in the short term. And, he says, "I expect demand to continue to outpace supply for tax-exempts--a situation that offers investors significant upside for price appreciation relative to taxable securities."
"NORTH OF BULLISH." The arguments for buying munis are largely based on long-term trends. But the bond market has been trading more based on the economic news of the day. Deane, who describes himself as "a little bit north of bullish" on municipals, thinks the time to invest is now. Even though the Federal Reserve Board is expected to raise short-term rates for a sixth time this year, he says an additional hike--and any other negative news for bonds--has largely been factored into prices. Since few people are expecting good news, he says, "a major move is not going to be down, it's going to be up."
One of the nice things about buying muni bonds is that as long as you plan to hold them until maturity, you don't need to worry about interest-rate movements and price fluctuations. Conventional wisdom has it that individuals should create a portfolio of 5 to 10 issues. But if you stick with AAA-rated munis, there's no reason not to buy only one or two bonds for the tax-free income. Chitnis recommends bonds that have been "prerefunded" or "escrowed to maturity" and are backed by Treasury bonds. "When you can buy an individual bond that is the same quality as a Treasury bond, who needs diversification?" he says. These bonds often trade above par, but the higher yield should more than make up for the loss of principal.
NURSING NICHES. You can find good munis in a number of places. "California paper, relative to the rest of the industry, looks very cheap," says Deane. Some hospitals and nursing homes in areas where they fill a niche don't deserve the beating they've taken, says Peter Allegrini, manager of Prudential Municipal Bond-High Yield Series. But if you want to reach for higher yields by buying lower-rated issues, or there's a chance you might need access to the money, you should diversify across maturities or just buy a mutual fund.
Always check the bond's redemption provisions to make sure there are no circumstances under which it could be called. Even noncallable issues may have a "sinking fund," which municipalities can use to call small percentages of bonds each year. Also, check to see if the bond is subject to the alternative minimum tax. Most municipal bonds are not, but ones that serve a private purpose, such as industrial-development revenue bonds (IDRs), often are.
Be sure to shop around for the best price. Bond dealers and brokers do not make their money by commission but by marking up the price of the security. Markups can vary from 1% to 4% and tend to be lower when you buy directly from a bond dealer's own inventory rather than from a stockbroker, who usually will go to a dealer to find the bond you want. If you have to sell the bond, you'll get clipped again.
If you have a short-term horizon and aren't in the highest tax bracket, make sure you belong in tax-frees. "At two to three years, it may be better to be in Treasuries," says Joel Isaacson, a New York financial planner. To compare how you would fare in taxable vs. tax-exempt securities, subtract your tax bracket from 1 and divide that into the tax-exempt yield times 100. Using this formula, 2.70% (the average for all tax-free money-market funds, according to IBC/Donoghue) for someone in the 39.6% bracket has a tax-equivalent yield of 4.47%. The average taxable money-market fund yields 4.26%.
You will get the most value if you buy bonds that mature in 10 to 15 years. But keep in mind that the longer the maturity, the more interest-rate risk you take on--and the more likely your circumstances could change, perhaps forcing you to cash in your bonds. If you want securities that mature in more than 10 to 12 years, invest in a mutual fund, Deane recommends. Aside from professional management and diversification, mutual funds offer ease of entry and exit. If you don't need to spend the income, they also simplify reinvesting.
RATING GAME. The case for buying individual securities instead of mutual funds gets more compelling in a rising rate environment. Bond-fund yields have a tendency to lag behind interest-rate movements, which gives them an advantage when rates are falling but makes individual new issues look more tempting when rates are going up. As a result, cash flow into tax-free funds has slowed substantially. At the end of 1993, there was $201 billion in municipal-bond funds, vs. $187 billion today, according to IBC/Donoghue's Bond Fund Report. Deane suggests the problem is not less demand but more individuals deciding to pick their own securities.
"People are going through a whole reevaluation of municipal-bond funds," says Isaacson, who puts most of his clients in individual bonds. While the drop in total returns of 3.92% this year has not been that major, the decline in principal, or net asset value, has been severe: 7.38%, says the Bond Fund Report. "People will say: `Why should I buy your fund, which is yielding 6.5%, when I can get an AAA-bond for 6.5%?"' says Allegrini.
In addition to the convenience, the answer is that a savvy fund manager can minimize losses. "With a managed fund, you don't just have to play offense, you can play defense," says Deane, who has limited his fund's losses for the year to 0.42%. Last October, when he thought the bond market was looking much too expensive, he brought the average maturity of his fund down from about 27 years to 15. He brought his cash position up to 10% and began using futures to hedge. Today, he's holding no cash, has moved the average maturity back up to 22 years, and doesn't have any hedges in place.
Whether you want to put the extra effort into purchasing individual securities or choose a mutual fund, muni- cipal bonds are emerging as the best choice among fixed-income investments. Keep your eye on them, even if you choose to wait until the market gets a little less wild.
A MUNICIPAL-BOND BUYING STRATEGY
-- Unless you plan to hold bonds to maturity, diversify across 5 to 10 issues.
-- Stick with AAA-rated issues or even safer "prerefunded" or "escrowed" bonds so you don't have to worry about credit risk.
-- Make sure there are no hidden bond call provisions.
-- Comparison shop. You will usually get better prices from a bond dealer than from a stockbroker.
DATA: BUSINESS WEEK
MUNI FUNDS VS. INDIVIDUAL BONDS Maturity (yrs.)* Fund Current yield AAA noncallable bond Yield ** 2.5 Vanguard Municipal 4.26% Sacramento, 4.7% Limited Term Prerefunded (6.625%, 2/1/97) 10.0 Dreyfus Intermediate 5.22 Longview, Tex. 5.5 Municipal Bond CGIC Insured (6.35%, 3/1/04) 10.0 Fidelity Spartan New York 5.29 New York State, 5.5 Intermediate Municipal Bond FGIC Insured (5.55%, 8/15/04) 20.0 Fidelity Municipal Bond 5.73 Pittsburgh, 6.1 FGIC Insured (7.25%, 9/1/14) *Average weighted DATA: STOEVER GLASS & CO. **At maturity