About 1.25 million Americans would pay more in taxes next year if President Barack Obama's latest plan is approved. The White House wants to allow taxes to rise for households making more than $250,000 by boosting the top marginal tax rates to 36 and 39.6 percent (currently, it's 33 and 35 percent).
In an environment where government policy favors higher taxes, investments that lower a tax bill can look attractive. I asked John Derrick, portfolio manager of U.S. Global Investors' tax free funds, to give an update on the municipal bond environment and how some of the fiscal challenges are affecting municipalities today.
Frank Holmes: A few years ago, it was predicted there would be a possibility of municipal bond defaults. Has that happened?
John Derrick: It's been more than two years now since well-known banking analyst Meredith Whitney declared on 60 Minutes that there would be massive bond defaults across numerous municipalities. We were skeptical of this prediction at the time and have not seen this happen to date. In fact, municipal bonds are as resilient as they have historically been. A recent report from Moody's Investors Service found that defaults for rated municipal bonds remain extremely low, with only 71 defaults from 1970 to 2011. About 73 percent of those defaults occurred in the family affordable housing and not-for-profit health care sectors-only five were general obligation bond issues.
What do you think accounts for the difference between these two types of bonds?
General obligation bonds, such as school district bond issues, are backed by taxpayer dollars, and essential service revenue bonds, including water, sewer or electrical utility issues, are backed by water or sewer bills. We find that, in general, residents have continued to pay their bills, and cities generally pay their bond payments, while cutting expenses in other areas.
Moody's indicates that municipal issuers, such as cities or school districts, have a lot to lose when they default because it causes significant borrowing difficulties in the future and some issuers could face higher borrowing rates. It's kind of like the equivalent of an individual's credit rating-if you stop making payments or default on a loan, you could face higher borrowing costs in the future.
Further, issuers in the health care and housing sectors usually face competition and economic volatility in their local markets.
With any bond purchase, we believe investors should be aware of any factors that may affect an issuer's ability to pay.
Can you give us some examples of recent news in the municipal market?
Extreme examples include the cities in California seeking bankruptcy, including tiny resort town Mammoth Lakes, San Bernardino and Stockton. Stockton is the largest city in the nation to file Chapter 9, as the city was encumbered with rising retiree health-care costs, decreasing tax revenues and a high foreclosure rate.
On the positive side, two California cities are having success with improving their budgets while still paying debt service. In San Diego and San Jose, voters overwhelmingly approved cuts to retirement benefits for city workers. This action will help improve their financial situations while still paying debt service on outstanding bonds.
With U.S. Global Investors offering two bond funds, how do investors choose between the funds?
The Tax Free Fund (USUTX) invests in municipal bonds that generally have longer maturities and is focused on providing a higher level of tax-free income. The Near-Term Tax Free Fund (NEARX), which has an overall Morningstar rating of 4 stars, invests in municipal bonds with relatively short maturities of generally five year or less and seeks to provide tax-free monthly income and stability.
From a credit perspective, both funds seek high-quality bonds. The fund's net assets are invested in investment grade municipal securities. This means, at the time of purchase, the ratings on the bonds must be rated at least BBB or equivalent by Moody's Investors Services or Standard & Poor's Corporation. If there's no rating, it needs to be determined to be of comparable quality.
Right now, the Bush-era tax cuts are set to expire at the end of this year, but with election season underway, it's unlikely we'll see a solution to this fiscal cliff. This could mean a higher tax bill for all Americans. As Winston Churchill once said, "We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle." In face of higher taxes, tax free bonds could be an investor's tool.
*Among 130, 130, 109, and 74 municipal short-term funds, the Near-Term Tax Free Fund earned 4 stars for the overall, 3-, 5- and 10-year periods ending 6/30/12.
Notes: Please consider carefully a fund's investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.
Morningstar Ratings are based on risk-adjusted return. The Overall Morningstar Rating for a fund is derived from a weighted-average of the performance figures associated with its three-, five- and ten-year (if applicable) Morningstar Rating metrics. Past performance does not guarantee future results. For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund's monthly performance (including the effects of sales charges, loads, and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. (Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.)
All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.
Tax-exempt income is federal income tax free. A portion of this income may be subject to state and local income taxes, and if applicable, may subject certain investors to the Alternative Minimum Tax as well. Each tax free fund may invest up to 20% of its assets in securities that pay taxable interest. Income or fund distributions attributable to capital gains are usually subject to both state and federal income taxes. Bond funds are subject to interest-rate risk; their value declines as interest rates rise. The tax free funds may be exposed to risks related to a concentration of investments in a particular state or geographic area. These investments present risks resulting from changes in economic conditions of the region or issuer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.