BERLIN – Regardless of who is elected president in November, congressional leaders are likely to push for higher tax rates for top income earners. That would erode their return on investments, with one notable exception: municipal bonds. Interest income from municipal bonds is exempt from federal taxation, so in the event of a tax hike, municipal prices could be expected to rise because the value of their tax-free income would increase.
Currently, municipal bonds are especially attractive because of their solid tax-exempt returns.
“They are unusual bargains compared to Treasuries,” said Martin Mauro, Fixed Income Strategist for Merrill Lynch’s Research Department.
Their appeal can be traced to turmoil in the credit markets. Last summer, as concerns about mortgage defaults and the safety of bond insurers flared, investors sold municipals and took refuge in the safest securities of all, Treasuries. That shift drove Treasury yields down because the federal government is able to offer lower rates for Treasuries when demand for them increases. In the volatility of the February market, selling by hedge funds and other traders depressed the prices of municipals even further.
Under typical circumstances, depending on the maturity of the securities, high-quality municipal bonds generally deliver 65 percent to 85 percent of the yield that Treasuries do. If a 10-year Treasury yields 5 percent, for example, a municipal of the same maturity might yield 4 percent. Investors accept the lower yields because of the tax advantages offered by municipal bonds. Generally, when taxes are factored in, the tax-exempt income produced by municipal securities exceeds the after-tax income generated by taxable investments.
In late February, an interesting statistic emerged: 10-year AAA-rated municipals were yielding 3.66%; for an investor in the 28 percent tax bracket, that was equivalent to a taxable bond yielding 5.08 percent. By comparison, 10-year Treasuries were yielding 3.62 percent. So municipal securities were yielding more than Treasury securities, making them attractive investments without even taking into account their federal tax exemption.
Are municipal bonds risky?
“Default rates on high-quality municipals should remain very low,” Mauro said.
Even in a recession, he notes, most municipalities should have adequate revenue to make the interest payments on their bonds. Mauro suggests that investors stay with investment-grade bonds rated A or higher by Standard & Poor’s. He also prefers municipals supported by solid income sources, particularly general obligation bonds, which are issued by states and cities and are backed by the municipalities’ full taxing power.
Mauro adds a note of caution about insured municipals. A municipal bond might be rated single-A on its own, but then be rated AAA because an insurer pledges to stand behind the scheduled payments of coupon and principal. This enables an issuer to cut its interest costs, because top-rated bonds pay relatively low yields. In recent months, however, some bond insurers have suffered losses because of their coverage of subprime mortgage securities. As a result, some investors are worried that the insurers will not be able to meet their insurance obligations in the event of municipal bond defaults. To avoid this, Mauro suggests sticking with insured bonds that are solid risks in the absence of the insurance coverage. In our opinion, if the underlying rating on a bond is A, the issue is unlikely to default, even if the insurance coverage vanishes.
Your financial advisor can help you assemble a diversified portfolio of solid municipal bonds with the goal of providing a reliable income stream.
(The writer is a Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-9084.)