5 Common Mistakes Muni Investors Make and How to Correct Them

Nobody's perfect.

That's true for municipal bond investors too. Despite best efforts, muni investors often unknowingly make mistakes with their portfolios which can lead to poor financial outcomes. The good news is that most mistakes can be corrected. We've identified five common mistakes that investors make and how to correct them.

A common mistake that we see among all bond investors, is to delay investing in intermediate- or long-term bonds until the Federal Reserve (Fed) has finished hiking rates. We think this is a bad strategy for two reasons.

First, by waiting in short-term investments, like cash, investors are foregoing the higher yields and higher income that longer-term bonds may offer. That can add up over time. For example, consider a municipal money market fund that yields 0.7% and a one-year AAA-rated municipal bond that yields 1.5%. By investing in the one-year muni, an investor locks in the 1.5% yield whereas the yield on the money market fund will fluctuate–likely moving higher as the Fed hikes rates. However, for the income to be the same after one-year, the yield on the money market fund will have to increase by roughly 0.12% every month to about 2.2% after one year. That may be possible but it's a big ask.

The second reason that waiting to invest is a bad strategy is because even though the Fed is hiking short-term rates, long-term rates may not rise. Historically, muni yields have peaked before the Fed hiked rates. The lone exception was during the rate-hiking cycle that started in the late '90s, when muni yields rose while the Fed hiked rates.

Instead of betting on when the high in rates will occur, consider spreading out the maturities of your investments, a strategy called a bond ladder. Instead of buying bonds that are scheduled to mature during the same year, you invest in bonds that mature at staggered future dates.

Many investors prefer to only buy munis issued by their home state because they are usually exempt from state income taxes. A better strategy is to also consider bonds from outside your home state because it could result in higher yields even after accounting for taxes and better diversification benefits.

First, some out-of-state muni bonds offer higher yields than in-state munis, even after taking any state income taxes into account. But it depends on where you look. The table below shows the yields investors in certain states would have to earn on out-of-state munis compared with the yield on an index of 10-year munis issued by their home state to compensate for the lack of state income tax breaks. This assumes the investors are in their home states' highest marginal state tax bracket. The difference in yield is expressed in basis points (a basis point is one hundredth of one percent, or 0.01%).

For example, the yield on an index of 10-year general obligation bonds issued by the state of California is currently 2.55%. An investor in the highest marginal state tax bracket (which, in California, is 13.3%) would have to earn a yield of at least 2.94%—or 39 basis points more—on a bond from outside of California to achieve the same after-tax yield as on the in-state bond. It may be possible to achieve this higher yield in this instance, but it may mean taking on additional credit risk.

Even if you can't achieve a higher yield with an out-of-state muni, the benefits of diversification are worth considering. There are approximately $3.7 trillion of muni bonds outstanding spread among thousands of issuers, and the credit quality of each state and issuer is affected by different factors. Even if you live in a state with many highly rated issuers, it could be beneficial to diversify nationally because those highly rated issuers are subject to similar credit risks, such as economic, political, and demographic risks.

Most investors should consider adding some munis from issuers outside their home state for potentially higher yields and broader diversification. Only for investors in California and New York does it make sense to stick with a portfolio of all in-state munis, in our view. The reason is, both states have a high state tax rate and enough issuers to achieve adequate diversification.

The municipal bond market is made up of over 50,000 individual issuers so it's incorrect to assume that every issuer faces the same problems to the same degree. Bad news in one city doesn't mean bad news everywhere. Consider the example of Chicago and Detroit.

On July 18^th, 2013, the city of Detroit filed for what was the largest municipal bankruptcy at the time. This caused some investors to think it was just the tipping point for other lower-rated cities, like Chicago, to file for bankruptcy protection as well. As a result, prices of Chicago general obligation (GO) bonds fell when the market first anticipated Detroit's bankruptcy filing and continued to fall after Detroit filed. Prices recovered some of the losses, but Chicago GO bond investors who sold because they assumed Chicago would go the way of Detroit may have lost money.

Detroit and Chicago is just one example of incorrectly applying one issuer's financial problems to another issuer. Understanding and overcoming this mistake can lead to better financial outcomes.

Having a financial plan and understanding the role of each investment can help prevent you from negatively reacting to headline risks. If you own individual bonds, knowing the source of revenues backing your bonds can help as well. This information can be found in the bond's offering statement on Schwab.com. An investment option that uses professional credit management can help if you prefer not to wade through financial disclosures.

You might earn higher after-tax yields (without compromising risk) if you understand your tax situation better.

Municipal bonds pay interest income that is usually exempt from federal income taxes, which can make them an attractive option to investors in high tax brackets. However, they're not exclusively for investors in the top tax brackets. Currently, municipal bonds yield more than corporate bonds after taxes for investors in the 32%-and-above tax brackets, as illustrated in the chart below—but that changes. The tax rate at which corporate bonds yield the same as municipal bonds after taxes has been as high as 50% and as low as 14% over the past five years.

Start by reviewing your tax situation with your tax advisor. If you're in the 32%-or-above brackets, munis will usually yield more than corporate bonds or Treasuries after taxes. However, that won't always be the case. If you're in the 24%-or-below brackets, before considering munis, evaluate highly rated corporate bonds or Treasuries, as they may yield more after taxes.

Also consider the tax bracket that you anticipate being in in the future. For example, if you are currently working and have a large amount of earned income but plan on retiring soon. You won't receive as much earned income in retirement, so your tax bracket will likely drop. In this case, munis won't yield the most after considering the tax impact.

There are two primary risks when investing in municipal bonds–credit and interest-rate risk. Considering both credit and interest-rate risk can lead to optimal outcomes.

Credit risk is the risk that an issuer won't pay interest or principal payments on time, known as a default, or the issuer will be downgraded, causing their bonds to fall in price. The risk of default is low with municipal bonds, but not nonexistent. To illustrate, over the past five years, fewer than 600 issuers, or slightly more than 1% of the total muni market, have defaulted. Most of the defaults have been in unrated or below-investment-grade munis. Although the risk of defaults is low, it increases with lower-rated issuers. However, lower-rated issuers usually yield more than higher-rated issuers because of this increased default risk.

Interest-rate risk is the risk that rising rates will cause bond prices to fall. A metric to quantify this risk is duration. Bonds with longer durations, or longer maturities, are more sensitive to changes in interest rates, as illustrated in the chart below. However, bonds with longer durations usually yield more than bonds with shorter durations to compensate for that risk.

Not optimizing the trade-off between interest and duration risk can lead to lower returns. Investing only in short-duration securities will likely mean low yields. Alternatively, taking on too much risk could result in a municipal bond portfolio that is more volatile than you're comfortable with.

We believe the bulk of a muni bond portfolio should be in higher-rated issuers. Investors with a higher risk tolerance should consider adding both some lower-rated investment-grade issuers and longer-duration bonds, like seven to 10-year maturities, for higher yields. We would caution against combining interest and credit risk. Instead, if investing in lower-rated munis, make sure their maturities aren't too long; the length of time will depend on the investor's risk tolerance.

Investing in municipal bonds can be complicated, but it doesn't have to be. By taking steps to mitigate these five common mistakes, we think muni investors will be better off over the long run. For help determining the right investments and strategy for your situation, talk to your fixed income specialist today.