Muni bonds for income and tax savings


It’s tough to find yield in fixed-income markets but one currently unloved sector to potentially consider is municipal bonds, especially for taxable accounts.

Individuals living on a fixed income are heading into the sixth year of safe bank deposits paying less than 1%. The so-called tax equivalent yields of diversified muni bond funds and ETFs are very attractive at a time when money market funds are yielding next to nothing and interest rates remain very low.

For example, the $3.1 billion iShares National AMT-Free Muni Bond ETF (MUB) has a tax equivalent distribution yield of 5.67% when the highest federal individual income tax rate of 43.4% is assumed. That’s why muni bonds have long been a favorite of high-net-worth investors. The income thrown off by most muni debt is exempt from federal income taxes.

“We use muni bonds in taxable accounts,” said Matthew Pierce, founder and portfolio manager at Island Light Capital, which manages the Income Portfolio on Covestor’s platform. “We like the relative safety of muni bonds compared to corporates, and they can make sense when Treasury yields are low.”

However, many investors are skittish on muni bonds in the wake of Detroit’s bankruptcy filing and concerns over Puerto Rico’s economy and debt obligations. These developments highlight the shaky finances of many local and state governments after the credit crisis. Also, muni bonds came under in pressure in late 2012 when fiscal cliff negotiations went down to the wire amid speculation the asset class could lose its tax benefits.

The recent news on Detroit and Puerto Rico has put investors on edge. Muni bond mutual funds and ETFs have seen net outflows for 24 straight weeks.

Yet when it comes to worries over the credit quality of muni bonds, Pierce notes that defaults are “historically very low, especially relative to corporate debt.” For muni bonds, the default rate is less than 1%.

“The default risks of muni bonds may be less than you think,” Pierce said. Also, getting access to muni bonds via index funds and ETFs provides diversification. For example, iShares National AMT-Free Muni Bond ETF (MUB) has only 3.1% of its portfolio in Puerto Rico.

Muni bond funds certainly aren’t risk-free and they are impacted when interest rates rise. Still, overblown credit worries may be causing individuals to miss out on decent yields, especially affluent investors in taxable accounts.

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