by Thomas Dalpiaz
Of all the words that could be used to describe municipal bonds as an investment, perhaps the best one would be “necessary.”
Other investments may garner more attention, have more interesting stories to tell or, generally, offer more punch. But by quietly meeting a number of important needs for individual investors, municipal bonds can be characterized as a most necessary investment.
Why are municipal bonds so necessary? Simply put, they get important investment jobs done.
Municipal bonds provide safety. Municipal bonds have an extremely low actual default record, second in safety only to U. S. Treasury obligations. Of course, there are municipal bond credit pitfalls that the uninitiated can fall into. There have been a few very large, well-publicized credit problems in the municipal market, as well as a host of very small credit problems from relatively obscure issuers. A municipal bond investor working with a professional bond manager, however, can avoid these pitfalls and uncover attractive yields by investing beyond the most pristine, highest quality municipal bonds.
Municipal bonds provide liquidity. Municipal bonds are widely held, have no holding periods or restrictions, and can be readily sold on any given business day. In fact, entire portfolios can be liquidated in a matter of days if necessary. A municipal bond investor can improve portfolio liquidity by working with a professional bond manager and their network of institutional broker/dealers.
Municipal bonds offer tremendous variety. This enormous variety in bond issuers, security features, credit quality, coupons, maturities, calls, puts and sinking fund features provides investors with two main benefits.
First, the plentiful choices among municipal bonds allow for easy diversification in portfolios. This contributes greatly to capital preservation (avoiding pitfalls) and consistency in returns. Second, the variety in municipal bonds allows for easy customization, as well. The ability to customize easily with municipal bonds gives investors the benefit of being very precise about the level of risk, return and tax-effectiveness that they can create in their bond portfolios.
Municipal bonds provide attractive after-tax returns in a conservative investment. Of course, there’s no denying that there are investment vehicles out there with higher stated yields or returns.
In fact, when surveying investment choices, it is very easy to focus simply on the yield of a particular investment without fully taking into account the taxes that need to be paid or the risk incurred to generate that yield. But investors must pay strict attention to the actual after-tax yield being generated by an investment, as well as the risk and dependability of the investment itself.
For higher-tax-bracket investors in particular, municipal bonds regularly offer attractive after-tax returns among conservative investments. For example, high tax bracket investors would have to find a Treasury bond yielding 3.76 percent in 2008 to equal the 2.45 percent yield in your pocket from an insured, five-year-maturity municipal bond currently available (a 3.25 percent muni yield is similar to finding a 5 percent Treasury).
Municipal bonds are great vehicles for preserving capital and managing volatility. This is perhaps the most important reason that municipal bonds are so necessary for individual investors. All investors face the risk that their investments will fluctuate — sometimes greatly — in value. Municipal bonds, properly managed, can help smooth the volatility of an investor’s total investment picture, regardless of age and investment objectives.
Municipal bond yields typically exhibit less volatility than Treasury or corporate bond yields. This occurs for a number of reasons. Generally speaking, municipal bonds have credit quality changes that develop slowly. Also, muni bonds are used as trading vehicles to a much less extent than Treasury or corporate bonds. Finally, municipal bonds provide after-tax yields, so they do not have to adjust as much as taxable bonds to a given interest rate change. A diversified, investment-grade, short/intermediate municipal bond portfolio is highly likely to produce sufficient coupon income to generally offset principal declines from moderately rising rates.
The “managing volatility” aspect of municipal bonds is particularly important for investors, since it can help in dealing with other investment classes. Even the most experienced investors can find it difficult to stay with their overall investment plan during periods of extreme volatility.
Investors should hold just the right amount of bonds that gives them the peace of mind to maintain a steady presence in the stock market. This bond allocation will vary for each investor. A long-term, steady commitment to the stock market (without the self-defeating urge to time the market) gives investors a better chance that they will capture the average, long-term returns expected from stocks. An appropriate bond allocation can help investors do that.
Safety. Liquidity. Abundant variety for diversification and customization. Attractive after-tax yields among conservative investment choices. Capital preservation characteristics for smoothing the volatility of an investor’s total investment picture. Help in staying with your equity exposure. That is an impressive list of investment tasks, all of them well handled by municipal bonds.
Interest rate and stock market cycles come and go. The lure of attractive yields and returns on a variety of traditional and newfangled investments is constant. Through the ups and downs and the exciting stories promising investment success, municipal bonds continue their quiet, effective work. Through it all — for all that they do for high tax bracket individual investors — municipal bonds remain a necessary investment.
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