Are Municipal Bonds A (Good) Hedge For You?

Bond rates and yields

Bonds, rates and yields – municipal and otherwise.

With the stocks trading with price/earnings multiples as lofty as they are, it would be prudent to consider other investments that may provide solid returns while weathering potential market corrections.

It seems everyone is on the edge of their seats wondering about when the Fed will raise interest rates. It’s almost inevitable because, well, they’ve said so and because it’s not like rates can really go any  lower. Unless you’re Europe. Then you can, apparently, go below zero.

Anyway, it appears that municipal bonds (“munis”) are one area that may (and I caution may) provide a hedge against stocks. Priced as they are, the market currently seems to regard the act of buying them with only slight preference to placing one’s hand on a loaded mousetrap.

What They Are

Bonds generally have terms of more than one year, often decades in duration (debt instruments for periods of less than a year are referred to as notes).

Municipal bonds are issued by state, county and city governments or other local government entities to fund general operating obligations or specific public projects such as airports, public utilities, toll roads and schools.

Bond repayment can come from tax revenues or operations, in the case of projects that produce revenue. The U.S. market for municipal bonds is well established and the value of outstanding bonds is well over $3 trillion.

Benefits

Munis backed by fiscally sound governments and agencies can be solid, attractive investments, depending on yield. If the marketplace is shying away from them, and risk turns out to be overpriced, the returns will be good.

Many munis are also exempt from federal, state and local taxes. These vary not only with the issuer but also your specific tax situation. For example, if you live in a different state from the state where the bonds were issued, that income may be subject to taxation in the state in which you reside. It’s advisable to see a tax professional beforehand.

However, if some or all of the interest income is tax exempt in your situation, right off the bat that is a significant, guaranteed net return.

Risks

Like any other investment there are risks. The main concern, particularly these days, is the risk of default such as the case with the city of Detroit. When the city filed bankruptcy in 2013 and defaulted on its bonds, it was the largest such case in U.S. history. The mess in Puerto Rico with its electric utility’s bonds isn’t helping either.

You might say Detroit and P.R. wet their shorts in the municipal bond pool, and investors are swimming the other way. Meanwhile, things are coming to a head internationally with Argentina embroiled in lawsuits and potentially defaulting on its sovereign debt too.

Another significant area of risk is when interest rates change. If they fall the value of current bonds rise. This is extremely unlikely to happen in the current interest rate environment, considering rates are basically zero now. They are almost certain to rise, it’s just a matter of time. And when they do, prices of current bonds will fall, assuming everything else remains the same (which may not be a good assumption).

There’s also the risk of bonds being called early. Callable bonds allow issuers to pay them off in full before maturity. While investors don’t lose their principal, they lose the future interest payments and have to find new investments with comparable risks and returns – not always a possibility.

A fourth area of risk is liquidity. If you’re holding munis and you need cash, how soon can you sell and will you have to take a haircut? This is only an issue if you don’t hold a bond to maturity.

What to Consider

Creditworthiness is key. Moody’s, Fitch and Standard & Poor (S&P) are the major rating firms. This table shows compares the investment-grade rating designations for each of the firms. While the nomenclature for different grades varies with each firm, the highest rating of AAA is consistent for all three.

While these rating firms are long established, in light of what happened with the mortgage backed securities (MBS) debacle that was part of the housing meltdown, in which bonds they rated as investment grade turned out to be little more than polished cow dung, I’d be cautious about taking their muni ratings as gospel. Still, it’s probably better than guessing.

Interest rate changes are another story. As mentioned above, when rates rise, prices fall if yields are to remain the same. One big reason yields are currently as high as they are could be that the market is saying, “Well, we’re pretty sure interest rates are going to rise at some point in the not-too-distant future so we’re baking that into current muni pricing.” When rates rise, prices will fall to maintain yield. How much they’ll fall is the question.

Then there’s the issue of income tax exemption, something of particular interest in an era of rising personal income tax rates. Many muni bonds are exempt from some or all income taxes so it pays to compare them with other potential investments on an after-tax basis.

These are some of the major considerations of investing in munis, and to a larger extent investing in bonds as a whole. As far as when to enter the fray, it may be wise to wait until rates begin to rise and bond prices fall. The questions then are how much rates will ultimately rise, and where bond prices will end up. The timing is never perfect.

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