Municipal bonds are an ideal alternative to low-yielding cash allocations and could be the perfect place to invest in an environment of rising taxes, according to Thomas Dalpiaz, a portfolio manager at Advisors Asset Management Inc.
The firm has $4.2 billion under supervision and Mr. Dalpiaz manages $200 million worth of separate account muni bond portfolios, mostly on a subadvisory basis for financial advisers.
He explained that while potentially higher interest rates and individual bonds' credit quality must be considered, the muni bond market offers opportunities for relatively secure yield.
“Right now there's no escaping the steady demand for muni bonds,” he said.
When it comes to muni bonds, investors get the automatic benefit of interest income that is exempt from federal and most state taxes.
In high-tax states like California, New Jersey and New York, an allocation to muni bonds can be particularly important, Mr. Dalpiaz said.
“The first thing we consider when building a muni bond portfolio is where the client resides,” he said. “In states like Texas, where there is no state income tax, investors can handle a national portfolio, but in the high-tax states, you want the local paper.”
Despite the headlines touting the dire financial straights of most states and municipalities, Mr. Dalpiaz said the long-term fiscal stability of municipalities issuing bonds needs to be kept in perspective.
“A lot of these municipalities are currently pressured in ways they haven't been pressured in a long time, but that trouble is relative and it's also a matter of how you define trouble,” he said.
Historically, muni bonds have defaulted at a fraction of the rate of corporate bonds, Mr. Dalpiaz said.
“Municipalities are entities that exist because they provide services, and they don't just disappear the way corporations can,” he said. “No matter what you're seeing in the news, most municipalities are a long way from not being able to pay the interest on their bonds, and I don't believe there's any wave of defaults that's going to sweep across the muni bond market.”
[To view a slide show of the most financially distressed U.S. states — and therefore some of the best potential muni bond bets —
click here.]
One thing about muni bond investing that Mr. Dalpiaz said most investors might not consider is that size of the overall market.
“There are more than 50,000 separate issuers of municipal bonds,” he said. “You always have to keep an eye on the credit quality of the bonds, but even with all the difficulties and the headlines it's still a very broad market.”
One of the factors benefiting investors is the trend of issuers dropping the insurance coverage on their bonds.
According to Mr. Dalpiaz, municipalities have realized that most investors were less interested in the insurance than they were in the additional yield that comes when the insurance is dropped.
And this yield is showing up with just a little bit more risk.
The demise of bond insurance, Mr. Dalpiaz said, has driven muni bond yields above their historical averages.
A few years ago, he explained, the difference between a triple-A rated muni bond and a single-A rated muni was around 40 basis points. But today the difference is closer to 100 basis points.
“People are demanding more yield,” Mr. Dalpiaz said. “You have to know what you're buying because the issuers have stopped buying the bond insurance, but they're compensating investors with better yields.”
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