Great stocking stuffers: Muni bonds

Wealthy U.S. investors may be able to buy municipal bonds at some of the highest yields in seven months as issuers rush to borrow before year-end.

Yields on the second-highest-rated municipal debt are at levels not reached since May, according to a Bloomberg Fair Market Value index as of Dec. 6. Tax-free securities declined 2.29% last month, according to the Bank of America Merrill Lynch Municipal Master Index. That was the third straight monthly drop, which hasn’t happened since 2004, the index showed.

“There will be opportunities for astute investors to buy good-quality bonds at lower prices,” said Randy Beeman, managing director of The Wise Investor Group, a unit of Robert W. Baird & Co. Inc. that oversees almost $2 billion in client assets.

Munis of all maturities are “relatively cheap,” with yields in short- to intermediate-term securities particularly high, compared with Treasuries’, according to fixed-income strategists at JPMorgan Chase & Co. in a report dated Nov. 19. The bank’s analysts have raised their recommendation on tax-exempt munis to “cautiously positive,” from “neutral.” Bond yields rise as prices fall.

Prices are lower in part because of a heavy supply of bonds as issuers work to meet the Dec. 31 deadline to receive a 35% federal subsidy through the taxable Build America Bond program, said Richard Saperstein, managing director at Treasury Partners, which oversees $10 billion in assets.

BOND SUPPLY

When municipal issuers sell Build America Bonds, the deals are frequently combined with tax-exempt issuance, he said. States and municipalities borrowed about $39.6 billion last month, according to data compiled by Bloomberg.

Top-rated tax-exempt munis due in 10 years were yielding 2.78% as of Dec. 6, according to a Bloomberg valuation index. For the highest earners — those paying a 35% federal rate on income — a 2.78% yield on the securities is equivalent to a 4.28% taxable yield.

Investors should buy selectively while being mindful of the risk of credit downgrades or defaults, according to Mr. Beeman, who works with clients who have an average net worth of about $5 million. Strategies include switching to individual bonds, from funds, and diversifying holdings among states.

Withdrawals by investors from municipal bond funds last month also helped to lower prices. Mutual fund investors sold $5.4 billion of muni assets within two weeks in November, according to Lipper FMI, a research firm.

David Schwartz, a physician based in Atlanta, kept his investments in high-yield municipal bond funds last month even though his accounts with Fidelity Investments, The Vanguard Group Inc., T. Rowe Price Group Inc. and American Century Investments lost as much as 5%, he said. Dr. Schwartz, 57, has a “significant percentage” of his non-retirement savings in munis, he said, without giving a figure, and bought more Dec. 1.

“I decided to invest additional monies in high-yield bonds because share prices and yields were attractive,” he said. “Municipal bonds still have a low default rate, and tax rates may rise on the highest earners, which may make the bonds more desirable.”

Municipal bonds generally are exempt from federal taxes, as well as state and local levies, for residents in states where they’re issued.

FINANCIAL STRESS

While states and municipalities are coping with financial stress at “a level that has not been seen for decades,” defaults will continue to be isolated situations, Fitch Ratings Ltd. said in a Nov. 16 report. The average default rate for investment-grade municipal debt evaluated by Moody’s Investors Service from 1970 through 2009 was 0.03%, compared with 0.97% for corporate issues, the company said in February.

Defaulted securities stood at $2.48 billion year-to-date through October, compared with $7.28 billion in all of 2009, according to data from Richard Lehmann, publisher of the Distressed Debt Securities Newsletter.

Investors may want to consider buying individual bonds now rather than mutual funds or exchange-traded funds, said Paul Tramontano, chief executive of Constellation Wealth Advisors LLC, an advisory firm with about $4 billion in assets. ETFs generally track an index and trade on an exchange like a stock. Investors with at least $500,000 to construct an account of individual bonds can diversify by purchasing at least 20 different securities in $25,000 lots, Mr. Tramontano said.

Investing in funds could trap investors in longer-dated or lower-credit bonds than they’d like, he said.

Municipal bond ETFs may also experience bigger drops than the indexes they track, because the share price can vary more than the value of the bonds in the fund, said Robert Kane, founder of BondView, a website that provides information to investors in retail municipal bonds. The iShares S&P National AMT-Free Municipal Bond Fund hit a 16-month low of $100.40 on Nov. 16 and fell 2.79% in November, compared with a 2.25% drop for the index it follows.

Investor behavior is a risk of investing in funds, said Jason Thomas, chief investment officer at Aspiriant, a multifamily office with about $7.5 billion in assets. “If I own the bond directly, I can hold it through whatever volatility,” Mr. Thomas said. “If I’m in a bond fund and all the investors get scared and leave, that can impact my performance.”

REVENUE BONDS

Revenue bonds are attractive because they have dedicated sources of repayment such as water and power districts, transportation systems and industrial development, and may offer higher yields than general-obligation bonds, which are supported by tax revenue of the state or municipality, Mr. Thomas said.

Investors potentially can pick up additional yield from revenue bonds in states that have suffered from mounting budget deficits, such as California and Illinois. That’s because these issuers may offer higher yields even though their income stream is independent from the state’s budgetary woes, Mr. Saperstein said.

Mr. Kane said he likes essential-services-revenue bonds, such as those issued by the Puerto Rico Electric Power Authority, rated BBB+ by Standard & Poor’s, the third-lowest of 10 investment-grade ratings. The bonds offer investors an exemption from any state tax and provide higher yields because they’re rated lower than many municipalities.

Investors should diversify and own bonds from other states, especially those with better credit ratings, such as triple-A-rated Virginia and Maryland, and forfeit the state and local tax savings, Mr. Beeman said. Credit downgrades or investor panic could still drive down bond prices, said Paul Jacobs, a certified financial planner with Palisades Hudson Financial Group LLC, which manages more than $1 billion for 55 families.

State tax revenue in the third quarter rose 3.9% from the year-earlier period, the third consecutive gain, as a recovering economy boosted receipts from sales and personal-income levies, according to a study of 48 states by the Nelson A. Rockefeller Institute of Government.

Albert Lewis, a former retirement-planning specialist for Morgan Stanley, said he started reducing his municipal bond holdings six months ago because he feared that the issuers wouldn’t be able to pay.

“There may be some great bargains out there,” said Mr. Lewis, 69, who had $300,000 invested in individual municipal bonds. “But there are also lots of unidentified smoldering debt beneath the coffers of many a municipality.”

Investors who stay in the muni market should consider putting up to 35% of their municipal investments in intermediate-term securities, or bonds with 7- to 10-year maturities and higher yields, Mr. Tramontano said. The bulk of the portfolio should remain in shorter-term munis because of the potential for rising interest rates, he said.