High-yield muni funds can make some money, but risk's high
— -- People always sigh about the good old days, when you could roar down twisty country lanes in a '57 Thunderbird without seat belts, air bags or padded dashboards. All good fun until a moose struts onto the road.
Investors are also longing for the days — not too long ago — when you could get a 5% tax-free yield from a municipal bond fund. And you can still get a 5% yield from some muni funds. But they may not be worth the risk.
Municipal bonds are long-term IOUs issued by state and local governments — or municipal entities, such as toll roads, universities and airports. Muni interest is generally free from federal income taxes. If you invest in a muni issued by your state, the interest is free from state taxes as well.
Currently, a 10-year, high-grade muni bond yields 1.84%, according to Bloomberg. A 10-year Treasury note also yields 1.84%. This is peculiar: Most times, you get less interest from a muni because it's tax-free.
For example, suppose you get $1,000 in interest from Treasury notes. You'd owe taxes on your interest. Subtract 25% for the Feds, you're left with $750.
If you get $1,000 in interest from a muni, however, you don't pay federal tax on it. To get $1,000 after taxes on a Treasury bond, you'd need to earn 2.41%. Relative to Treasuries, muni bonds are attractive.
But that's on a relative basis. As you can see from this example, interest rates on bonds are so low that some issues are on suicide watch. On an absolute basis, bond yields are low.
And that's a problem — not just because you're earning a pittance, but because bond prices fall when interest rates rise. And at this level, your pathetic yet tax-free yield won't provide you with a great deal of cushion if prices fall.
A recent example: The yield on the 10-year T-note hit a record low of 1.39% on July 24. Rates have risen since then, and the average municipal bond fund is down 0.4%, including interest.
A traditional strategy for rising rates is a bond ladder — that is, you buy short-term bonds of the same maturity at regular intervals. As each bond matures, you'll theoretically be reinvesting your money at higher interest rates.
But you could be waiting a long time for higher rates — and in the meantime, getting very little yield. "You could build a ladder, but you'd still be on the ground floor," says Lew Altfest, CEO of Altfest Personal Wealth Management.
How can you get off the ground floor? Two ways. The first is to buy longer-term munis. When you buy a bond, you're a lender. You'd probably charge more for a loan due in 2035 than one due next Tuesday. The same is true with munis: High-quality munis due in 30 years yield 3.1%.
Here again, you're adding risk. A long-term bond's price falls more when interest rates rise than a short-term bond's price does. You're also locking in a very low yield for a very long time.
The other way is to invest in bonds with shaky credit ratings. Just as credit card borrowers with poor credit ratings pay higher interest rates, so do municipal borrowers. If these borrowers' credit ratings improve — a reasonable assumption in a recovering economy — then they should rise in price.
Bonds rated by the ratings agencies — Moody's, Standard & Poor's and Fitch — have remarkably low default rates. Only 71 muni bonds rated by Moody's have defaulted from 1970 through 2011, vs. 1,784 corporate bonds.
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