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MuniWatch: Investing Wisely in Municipal Bonds Todayby Rob Williams, Director of Income Planning, Schwab Center for Financial ResearchOctober 14, 2009 Key points:
Here, we'll discuss the most pressing current issues of interest to muni investors, including muni markets today, risk, how to consider tax advantages and how to invest wisely. Muni markets have rebounded Since the end of last year, munis have enjoyed one of their strongest nine-month periods of the past 20 years. Paradoxically, this has happened in the face of bad budget news across the country, a weak housing market, and steep declines in both income and sales tax collections. There are two main reasons, in market terms:
There's a bigger reason why muni bonds have recovered, though, that's likely to be more important to you—protection for investors in munis remain strong. The protection of principal isn't quite on par with Treasuries, but for the highest-quality municipal bond issuers, it's close. Despite the severe economic troubles, there have been no investment-grade defaults during the past year, and there were none in the previous 30 years either. Defaults can occur, but they almost never do, for investment-grade bonds (i.e. rated BBB/Baa or above). But let's broaden this discussion of risk: We're also talking about swings in price. This is especially concerning if you're not a buy-and-hold investor, or if you think seeing the value of bonds in your portfolio change might keep you up at night. Most investors want to limit volatility, especially in bonds. And we all want to buy good values, to ensure we've tied in good yields today. So, is now a good time to find that value, stability and the tax advantages in muni bonds? We believe that munis today are, for the most part, fairly valued. And there are ways to limit risk. How to determine value in muni bonds? One of the primary metrics helpful in evaluating the relative value of municipal bonds compared to other bond investments are yields on a broad range of muni bonds compared to Treasuries. Today, the difference in yields between a broad selection of the highest-quality munis and Treasuries are back closer to normal historical levels—municipal bond yields in the 70% to 80% range of equivalent Treasuries, as you can see in the chart below. This means that for average investors, the highest-quality muni bond will yield about as much as an equivalent Treasury after you factor in the state and federal tax exemption. You might earn a touch more, if you're willing to take on a bit more credit risk.
Source: Bloomberg, as of October 9, 2009. What does this mean to you?
Source: Bloomberg, as of October 9, 2009 How to invest? If your goal is primarily to preserve capital and earn a bit of additional tax-exempt return above money market fund or Treasuries, stick with the highest-rated muni issuers. These issuers have the most ability to absorb economic and financial stresses, and are generally rated AA-/Aa3 or higher. If you're aiming for slightly higher income, you might consider investing a portion of your portfolio in munis with slightly lower ratings—between A-/A3 and A+/A1—or slightly longer maturities. Limit your exposure here to 30% or less of your muni portfolio, due to the potential for more volatility in these issuers if weak economic conditions continue. Right now, we see the best trade-off between yield and interest rate risk in short- to intermediate term maturities (or four to eight years, or so, for the average maturity in your a portfolio or bond ladder) for investors with more than a short-term horizon. These maturities carry less risk that they'll lose their value than longer-term bonds if interest rates start to climb. The little bit of extra yield in longer maturities may not be worth the risks, especially if you're worried about inflation (and rising rates) down the road. Of course, you can also get exposure to all of these through a well-selected short- or intermediate-term municipal bond fund. What are the risks? Budget deficits and collapsing revenues, along with rising funding costs, might trigger a crisis mode for some state and local governments for the foreseeable future, if not years to come. The impact of falling property taxes, for example, can be felt for years, and can be slow to recover even as economic conditions improve. But highly rated issuers have many protections and guarantees in place to ensure that bonds are paid, even as local budgets are cut. Even at the height of the recent budget crisis in states like California, bonds continued to be paid. There was no discussion of default, even as IOUs were issued and expenditures cut. As lawmakers battled, many California general obligation (GO) bonds actually rose in price. If you protect yourself with diversification, these issues may not matter much to your portfolio. These days, diversification is cheap and easy to find. Try to limit unnecessary exposure—say no more than 10% of your total fixed income portfolio—to any single issuer or security. Here are some specific observations on a few of the nation's largest muni issuers, for investors in particular states or regions: New York City (AA/Aa2) New York City is one of the nation's largest and most sophisticated muni issuers, and went through its own near meltdown during the 1970s when it nearly filed for bankruptcy—but still never defaulted on its bonds. These days, the picture is rosier, despite a dramatic drop in income tax revenues. Sophisticated budgeting practices and the ability to respond to revenue shortfalls quickly and decisively have supported strong bond ratings. The city is also a participant in New York Port Authority bonds and other bonds secured by dedicated sales and income taxes. Collapsing revenues aren't good news, but there are many cushions in place. New York State (AA/Aa3) Like NYC, New York State confronts budget challenges. Like the city, analysts point to pro-active cost-cutting (politics notwithstanding) to match falling income sources. The state also sponsors a Housing Finance Agency, Dormitory Authority, Thruway Authority and other dedicated finance authorities. Some of the state-related authority bonds carry stronger credit protections than state GO bonds themselves, according to rating agencies, due to special "carve-outs" of revenues and protections. New Jersey (AA/Aa3 negative outlook) New Jersey residents pay some of the highest property taxes in the country. However, the impact thus far of the housing bubble has been limited compared to states with more speculative development such as Florida and other sun-belt states. Still, most states rely more on sales and income taxes than property taxes. Of the 50 states, 41 have income taxes as their leading revenue source. While income taxes often drop sharply, they also tend to recover more quickly than "slower" revenues like property taxes. This is one reason not to be as shocked by budget volatility in states like New Jersey, or others nationwide. If the economy recovers, states tend to recover more quickly. If they don't, they must cut spending before impacting long-term bond obligations. The ratings and credit quality of the state of New Jersey (and most others) are boosted by that pattern, but can and do change. The rating outlook for New Jersey, for example, was placed on "negative" outlook by Moody's in August because "of a sizable structural imbalance" in its budget resolved with "one-time" solutions. In other words, the state is biding time while it waits for revenues to rebound. Illinois (AA- negative/A1 negative outlook) Recent budget troubles in Illinois illustrate the importance of willingness, as well as ability to keep credit strong. State and local governments generally have the tools they need to keep budgets balanced, but they may not always have the will—they have to deal with politics. As a result of problems on that front, the state's ratings were recently downgraded. Is there risk of default? Not likely. But an inability (or lack of commitment) to make tough decisions has decreased the margin for error and increased the possibility of additional downgrades. California (A/Baa1) An issue we've continued to follow is the state's cash position, which was strengthened last week by the successful sale of $8.8 billion in new revenue anticipation notes (RANs). We expect to see additional headlines as the budget cycle begins again early next year, unless we see a miraculous rebound in state income and sales tax receipts. But the question remains: Does it matter for muni bond investors, given the credit protections? Important Disclosures Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors. Investment income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax. Capital gains are not exempt from federal income tax. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. 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