Is it wise to invest in municipal bonds in today's economy?

April 25, 2011

Municipal bonds are many physicians' favorite investment.

Some doctors also view municipal bonds as safe investments-at least until a well-known investment analyst predicted widespread municipal defaults on bonds' principal and interest payments. In other words, this analyst thinks of municipals not as solid investments but as junk bonds. Which view is correct?

It's true that many municipalities are having financial troubles. The recession has reduced their incomes, whereas their costs continue to rise. Moreover, after years of "cooking the books," many can't afford the retirement benefits previously agreed to in contracts with public unions.

IMPROVING ECONOMY

Meanwhile, the U.S. economy is improving, which has led to increasing tax revenues. Moreover, cities are asking their employees for givebacks in the form of increased contributions to their own medical or pension plans. In my opinion, if municipalities ever truly face widespread bankruptcies (which I believe is highly unlikely), everything will be on the table, including boosts in taxes and federal aid.

Municipal bond yields normally are about 80% of yields on comparable U.S. government bonds. The lower yield occurs because muni bonds are free of federal taxation, and if you buy those of the state in which you reside, of state and local taxation as well.

MUNI YIELDS UP

Reflecting current concerns, however, yields on munis actually are higher than they are on U.S. government bonds. Yields even for highly rated bonds are so high that even if taxable bond rates increase, municipal bonds could be cushioned from the effects.

Note that I am not saying that yields on muni bonds couldn't go higher. If investors continue taking money from them and buying taxable bonds, particularly at the same time that overall taxable rates increase, yields could continue to move up.

But I do believe that municipal bond rates, which can provide pre-tax equivalent yields in excess of 7% and 9% for people in the 28% and 45% marginal tax brackets, are attractive now. Waiting until you are psychologically more comfortable is committing the same mistake as seeking assurance that the market was bottoming when the Dow Jones Industrial Average was 40% lower than it is today.

Munis are priced less efficiently than government bonds, so attractive yields can become available when widespread bond liquidations occur, as has happened recently. (I know, because my firm has purchased them.) But if you are buying individual bonds, it can be difficult to know when yields are truly attractive and to avoid lower-quality bonds. Buying state-guaranteed obligations or revenue bonds that are covered by their own revenue sources without state aid should provide a higher level of safety.

For many investors, the best course of action may be municipal bond funds. Funds such as the Vanguard Intermediate Term Tax-Exempt Investment Fund, a country wide fund, present good expertise with relatively little overhead cost. As an extra precaution, forgo the tax deduction if you live or work in a state with income taxation, and place some money in a national municipal bond fund. The PIMCO Municipal Bond Fund, also a national fund, offers an excellent combination of expertise and reasonable cost.

The author is president of Altfest Personal Wealth Management, a financial and investment advisory firm in New York City; an associate professor of finance at Pace University, and a Medical Economics editorial consultant. The ideas expressed in this column are his alone and do not represent the views of Medical Economics. If you have a comment or a topic you would like to see covered here, please email medec@advanstar.com
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