Questions Loom for Muni Bonds Amid Rising Rate Outlook

Cities and states have long relied on investor IOUs.

We’re talking about municipal bonds, longtime investor darlings for their historically low default rates compared with corporate debt and their ability to generate tax-free income for retirees, or those approaching retirement. The U.S. muni market turned in an impressive performance in 2014, clocking a return of nearly 9% through late December, The Wall Street Journal recently reported, citing data from Barclays PLC. By comparison, the S&P 500 Index was up about 11%.

But as we forge into the new year, the big economic picture is shifting. Benchmark short-term interest rates, after grinding along at historic lows since the Great Recession ended, are poised to climb. This raises some key questions for the $3.5 trillion U.S. muni bond market (and a lot of other markets). Is now the right time to consider muni bonds, which can offer tax advantages for higher net worth individuals? And if you already own munis, are they keepers?

Rates vs. Taxes

By mid-2015, if not sooner, the Federal Reserve is widely expected to hike rates for the first time since 2006. As the central bank embarks on its next policy tightening phase, fixed-income investors would be wise to consider the far-reaching implications of a higher rate environment. The price of a bond moves inversely to its interest rate, a dynamic that reflects investors demanding greater returns to offset the risk of rising inflation. This principle applies to most any type of bond, including munis.

“Municipal bond prices are adversely affected by rising rates,” said Craig Laffman, director of fixed-income trading and syndicate at TD Ameritrade. “With rates still near generational lows, muni bond holders, and all bond holders for that matter, should review their portfolios to ensure they are comfortable with the risk level of bonds in their portfolio.”

If the interest rate climate in general leads to depressed bond prices, it may make more sense than ever to diversify into bond categories that deliver other features, such as tax-exempt status. Several tax provisions expired at the end of 2013. Among the changes: a top marginal rate of 39.6%, up from 35%; higher capital gains and dividend taxes; and a new 3.8% tax on investment income, from which muni income is exempt.  Municipal security interest may, however, be subject to the Alternative Minimum Tax.

Bad Rep?

U.S. muni bond yields in December ranged from around 3% to slightly above 4%. By comparison, the 10-year Treasury note yielded about 2.2%.

But even with tax advantages, muni bonds aren’t without risk, as the recent struggles of Detroit and Puerto Rico illustrate (the former defaulted, and bonds for the latter were cut to “junk” status in early 2014). Risk depends on the type of bond; for instance, bonds backed by utility payments may prove higher-rated than those backed by uncertain, economically-sensitive revenues. The riskiest of these bonds are called high-yield, or “junk.”

“If larger issuers (such as Puerto Rico) can successfully navigate through restructuring proceedings, it shows other municipalities a potential approach to address their own funding gaps, including pensions and outstanding obligations,” said Laffman. “Successful restructurings with minimal fallout to bondholders can also boost investor confidence.”

Sometimes, default stories can depress prices across the board. That can mean that investors have an opportunity to snag higher-quality bonds at a discount. In the bigger picture, first-time municipal defaults in 2014 were on pace to decline for the fourth straight year, according to Municipal Market Advisors.

Mainly, investors need to consider if they’re paid sufficiently for the risks they assume. For instance, what makes the most sense in this rate climate? Long-, short- or mid-maturity debt?

Investors may find they’re getting enough yield to compensate for any default risk without exposing themselves to extended maturities. Others may find the wider spread between longer-dated munis and Treasuries more attractive, even with the added risk. And given the run that the muni bond had in 2014, investors may feel compelled to shop around in higher-yield, higher-risk credits.

Many analysts say it may be hard to duplicate the broad muni market’s 2014 performance (which included a 13% return for sub-investment grade bonds). Still, a shortage of bonds amid issuer reluctance to take on big projects is proving supportive for prices.

Most important is how the market withstands all these challenges, and what selective diversification with tax-advantaged munis can mean for an individual portfolio.