Tis the season for municipal bonds. Last fall, tax-free rates nearly equaled the taxable-rates on bonds. From early November to early December the spread between 10-year taxable and the same term muni bonds narrowed to 90 percent. The bond markets were under pressure and municipals performed as usual. They fluctuated less than their taxable counterparts.
"Over time I’ve found munis to fluctuate at least a third less than equivalent taxable bonds," said Harris May, president, Strategic Partners Investment Advisors, Tarrytown, N.Y. May left a long-term career in institutional bond management 18 months ago to create a new firm managing separate accounts. His firm targets accounts of $750,000 to $1 million.
"The overwhelming majority of municipal bond owners take the income. They manage their mortgage to that amount, their vacation plans, their entire lifestyle. They need to depend on that income stream," May explains as the reason for munis’ lower volatility.
Another explanation is that more tax frees are owned by disciplined investors who don’t trade in and out. The lower, taxadvantaged yields appeal more to high-tax-bracket investors, who are more likely to seek professional advice. Professionals are less likely to trade and more likely to manage assets according to a disciplined plan based on the client’s long-term goals and not the vagaries of the market. "First we allocate a client’s assets to an appropriate percent of bonds," said Thomas Hofbauer, portfolio manager, Oberlin Financial Corp., of Bryan, Ohio. "Then, we analyze by client. It all depends on the personal situation of the client what percent of their bond holdings ends up in tax frees."
It might be the muni owners’ call for steady income that is the driving force behind how they participate in the market. Most go for outright purchases of bonds, not the fluctuating income stream offered by bond funds. "We buy bonds only - no bond funds," said Ann D. Jevne, CPA, PFS, CFP, Schwartz & Hofflich, Norwalk, Conn. "Buying bonds outright gives us the flexibility of making laddered portfolios."
Laddered portfolios are favored by many advisors. The ladder refers to the successively longer maturity dates of bonds in the portfolio. Issues are usually held to maturity, which eliminates concerns for fluctuation of principal. Maturing bonds are regularly reinvested so the portfolio keeps pace with changing interest rates on new issues of bonds.
Alexander S. Pasquale, president, Everest Consultants LLC, Syracuse, N.Y., also builds portfolios of individual bonds tailored for each client. Pasquale’s firm is one of a growing number of advisors using separate account managers for bonds as well as equities. "We use a professionally managed bond portfolio based on the state the client resides in and whether they seek the safety of insured bonds or not," said Pasquale. "The managers can trade the portfolios at their discretion but the one or two trades each year just improve the quality of the overall portfolio."
Individually managed bond portfolios match the individual client’s time horizon and risk parameters. But investors’ preferences sometimes go beyond credit rating and time to maturity. The principals of Strategic Partners work with the advisor on all aspects of the client’s Investment Policy Statement, including client prejudices. "Some clients won’t buy tobacco bonds or hospital paper," said May. "The Investment Policy Statement is at the heart of our activities for each portfolio."
Like other separate accounts, they can also be used to manage gains and losses across all accounts a client owns. Strategic Partners’ portfolio managers plan outgoing communication with advisors, updating them when bonds could be swapped and losses realized.
Bond funds have their place in holding assets. Hofbauer uses the Ohio tax-exempt funds for some clients. Other times the convenience wins out. "We always buy bonds outright from our different bond marketplaces," said Thomas D. Smedile, CPA, president and owner, Swarthmore Financial Advisors, Media, Pa. "But if the investable amount is just too small then we go to bond funds to get the proper diversification for the client."
The search for double tax-exempt bonds affects advisors on a state-by-state basis. While Hofbauer’s Ohio clients regularly benefit, Jevne rarely concerns herself with Connecticut state tax-free income. "We always search for the highest after-tax return," said Jevne. "Connecticut tax exempt returns are usually lower than if we buy other state bonds and just pay the state tax."
Overall, advisors concede that municipal bonds are not very exciting investments. The analysis centers solely on credit quality, coupon rate and maturity date. But there are some unique hooks that advisors look for. Jevne is careful of buying private activity bonds for clients that pay alternative minimum tax because interest from those bonds is included in the AMT calculation. Hofbauer goes for higher yielding bonds for totally discretionary clients. "Right now the spreads have widened for high-yield so we’re moving some clients and gaining one-quarter to one-half point," said Hofbauer. "Some of the closed-end funds yield 5.25 percent to 5.50 percent and those look good compared to similar bonds."
Money manager Strategic Partners looks for situations like last fall to move more clients into municipals. Last November was one of those times. The 90 percent spread was above the average over the last year of 85 percent and significantly above the rate in January 1999 of 70 percent. "In times of stress on bonds munis outperform taxables," said May. "Those times provide great opportunities, especially for cross-over investors in lower tax brackets."
The conservative market action of municipals may be put to the test again. One enemy of bond prices is higher interest rates. Smedile jokes with his clients that the less-than-1-percent yield on their tax-free money markets is not much better than putting the money in a shoe box.
Pasquale’s firm is now underweighting bonds. "Investors have to realize that bonds can be just as volatile as equities," said Pasquale. "Going forward, I think that investors have got to be prepared that returns on bonds are going to return to normal."
