Rewards May Exist in Muni Bonds

Includes: MUB, MUNI, TFI
by: AAII

Worries about state and local government debt continue to drive money out of municipal (aka "muni") bond funds. The Investment Company Institute (ICI) calculates that muni bond funds incurred $2.4 billion worth of outflows last week. This was the 10th consecutive week of outflows. Since the week of November 10, cumulative outflows have exceeded $25 billion.

(The ICI monitors inflows and outflows for more than 95% of mutual fund assets. The data reflects portfolio changes for both individual and institutional investors.)

The outflows reflect concerns over fiscal problems at state, county and local governments. Declines in tax revenues caused by a weak economy combined with stretched budgets are the primary culprits, as you know. A lack of effective budgeting and planning is compounding matters for certain government entities. These are the factors that often make the headlines when muni bonds are discussed.

What doesn't make the headlines is the simple fact that municipal bonds vary greatly. Even within a particular state, there can be big differences in the credit quality of municipal bonds. This is why fears about the possibility of defaults are not an excuse for ignoring the entire asset class. In fact, it is possible that some muni bonds are trading at attractive yields relative to their credit quality. ( displays yield indexes by state and has other useful quote information about muni bonds.)

The difficult part is that researching individual municipal bonds takes time and effort. You have to know what revenue stream is tied to the bond and what safeguards exist for investors. For example, is it a general obligation bond or is it tied to a specific tax or revenue stream?

You also have to assess the fiscal strength of the government entity behind the bond. Even if a state is encountering budget problems (and many are), it may still remain far from default. Then there is the fact that not all municipalities use generally accepted accounting rules (GAAP). This means that not all financial statements are standardized. (The decision to follow or not to follow GAAP often comes down to cost and available staffing.)

The payoff for putting up with these hurdles is a potentially higher tax-adjusted yield. (Muni bonds offer tax advantages over other types of bonds and are most beneficial when held in a taxable account.) You may have to dig, but short-term fears can create opportunities for those who are astute and selective.

Buying municipal bonds is more complex than buying stocks, especially since government entities can have bonds with varying maturities and yields. Liquidity also varies widely.

It can be done, however, often through the same broker you are using for trading stocks. (Check with your brokerage firm.) A 2008 article in the AAII Journal, How to Buy Individual Bonds: A Fixed-Income Toolkit, provides suggestions on how to get started.

Disclosure: No positions