Finke: When Municipal Bonds Get Exciting

In the great 21st century search for investment yield, it makes sense to give a second look at old-school asset classes like municipal bonds that have historically offered boring returns at the right price to high-income investors. These days, even the boring returns can be exciting.

What’s sort of exciting about municipal bonds stems from a 19th century Supreme Court case that found that investors don’t have to pay federal tax on the income they receive from interest payments on munis. If you were paying attention in your finance class, you know that it makes sense to compare after-tax yields on munis with corporate bonds or other income-producing assets. If you’re investing in a tax-sheltered account, then you want to choose the most highly taxable bond (a corporate). If you’re investing in a taxable account then the net yield on a muni will rise with the marginal tax rate of the investor.

So high marginal tax rate clients investing in taxable accounts should consider munis as an alternative to corporate or federal bonds. For example, a high-income retiree looking to produce income from investments while preserving capital in a historically low-risk vehicle should at least consider a muni. Obviously, you want to consider what the client’s tax bracket will be in the future if they’re going to hold the bond longer than the current tax year.

Relative to federal bonds, returns on munis are higher than they should be. In an efficient market, the muni after-tax yield for high-income investors (the ones who set asset prices) will be about equal to Treasury bonds of the same duration. And they are, but only for short-term bonds. For longer-term bonds, the spread rises with the duration of the bond. The same goes for corporates—the after-tax return on munis of the same risk and duration often exceeds corporate bonds. This is considered a puzzle in the finance literature, but one that makes munis a good deal for long-term taxable investors.

Bond Behavior

Researchers had traditionally chalked up the higher yields on munis relative to Treasuries to a slightly higher default risk, or the fact that munis are often callable where Treasuries are not. The spread compared to corporates has been attributed to the difficulty investors often experience pulling residual assets from a default (see the Detroit muni bondholder fiasco), or the more opaque accounting rules for municipalities. But the fact remains that only about a half of 1% of municipal bonds defaulted in the United State during the latter half of the 20th century. Munis haven’t been very risky.

There’s also the non-zero possibility that a budget crunch will cause the federal government to rethink the tax deductibility of bond interest (a 1988 Supreme Court ruling says that they can). Bill Walsh, co-founder and president of municipal bond specialist firm Hennion and Walsh, doesn’t see this happening any time soon. He believes that a change in tax law “is certainly a possibility.” But even if politicians are able to surmount the considerable political pressure against raising taxes, Walsh thinks this won’t be a big risk for muni owners. “I think if anything happens they’ll change the future exemption and not the current exemption.” Grandfathering the tax exemption of current muni owners would increase the value of existing munis, which is hardly a risk.

One explanation for the favorable returns of long-term munis is the illiquidity of the municipal bond market. Munis trade far less frequently than Treasury bonds, and this illiquidity makes longer-term and lower-quality munis less attractive to investors. For example, investors may feel comfortable holding a muni maturing in one year because they won’t really care about selling the bond in the future. Lower-rated bonds that mature a few years in the future may also be less attractive to investors because it is often difficult to obtain information to assess the risk of default from a municipality. While there is a benefit to holding a longer-duration muni, they bear greater illiquidity risk.

Investors interested in carving out a portion of their fixed income taxable portfolio to munis face the challenge of building a portfolio of thinly traded securities. Since many munis are less liquid, spreads (the difference in the price to buy and to sell a bond) can be high. The transaction costs tend to fall with the size of the fund purchased. This means that it is a better deal to buy larger bonds—for example $100,000 vs. $10,000. Walsh, however, believes that transaction costs are falling to the point that less wealthy investors in a high tax bracket can efficiently invest in individual munis with par values as low as $5,000.

Although historical default rates on munis are very low, the highly publicized recent defaults of Puerto Rican bonds are a sobering reminder that idiosyncratic risk exists. If you’re building a muni portfolio with municipal bonds, pay attention to credit ratings and buy enough to provide some diversification protection.

Wealthier investors can take advantage of the triple whammy of higher after-tax returns, lower transaction costs on larger fund trades, and a better diversified muni portfolio. Financial planner and Texas Tech professor Harold Evensky believes that “if someone is going to diversify, they’ll need a minimum of 10 different $100k positions.” There’s no firm rule, but advisors need to balance the lower expenses of buying individual bonds with the costs of diversification.