Munis Now Offer Promising Investment Potential

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OCEAN CITY — Municipal bonds experienced a dramatic surge of interest in the past year. After a brief downturn at the end of 2010, when some analysts were predicting a wave of defaults, the asset class posted a 9.64% return (including both interest payments and price appreciation) in a 12-month period through June 8, 2012.

While municipal returns benefitted from a decline in interest rates that probably won’t be repeated, they are still attractive for the tax advantage that they offer over U.S. Treasuries — the interest they pay is normally exempt from federal income tax. Today, that makes them a potentially very promising, and very important, investment opportunity.

“The opportunity is exaggerated in this period of volatile financial markets and extremely low interest rates,” says Tom Latta, managing director and global head of Traditional Due Diligence at Bank of America Merrill Lynch. “So long as you’re selective and you align your choices with your overall investment strategy, munis can provide attractive after-tax income potential.” It’s important, however, to look at the different types of munis and get a clear picture of their unique advantages and risks.

For most individual investors, there are two primary categories of municipal bonds: general obligation (GO) bonds and revenue bonds. GO bonds are backed by the full faith and credit of the state or local government that issues them, and interest payments to bondholders come from general tax revenues. Revenue bonds are narrower; issued to finance a particular project, such as a stadium or a highway, these munis are funded by the revenues that the project generates. For example, a revenue bond issued to build a bridge might use bridge tolls to pay interest on the bond.

GO bonds are generally considered to have less risk of the two. One reason is that if a municipality has trouble meeting its obligations, it has the power to levy additional taxes. Another reason is that in order to reduce or eliminate payments to bondholders, a municipality would have to declare bankruptcy, and that is unlikely: States cannot legally do so, and a city or county would seriously jeopardize its ability to borrow money in the future were it to seek bankruptcy protection. Not all GO bonds are created equal, however. For example, GO bonds of a city with a young labor force and a robust economy based on energy production may offer lower risk of default than GO bonds issued by a city with aging workers and a tax base consisting largely of ailing manufacturers.

Revenue bonds, on the other hand, tend to be more sensitive to economic cycles. For instance, a bond issued to support a sports stadium may suffer if attendance wanes during a recession. Still, revenue bonds supporting essential services, such as wastewater treatment, are likely to remain viable regardless of problems in the larger economy.

Municipal bonds are sought after primarily to generate tax-advantaged income potential. And because munis typically have higher credit ratings, they can offset risk in the fixed income portion of your portfolio.

High-quality munis can also add noncorrelated diversification to a broad portfolio, performing well during periods when riskier assets suffer. That’s what happened during the last financial crisis. “In 2008, government and high-quality municipal bonds rose in price while everything else fell because they were perceived as government-supported safe havens,” Latta says.

Like most other bonds, municipal bonds are subject to both interest rate risk and credit risk. Interest rate risk is the possibility that a general rise in interest rates will reduce the price of an existing security. This is important for municipal bonds because of their long maturities; most munis are typically issued with terms of 10 or 30 years.

Consider how municipal bond trades work. Dealers build a cushion into their price to cover the time between buying and selling a security. That cushion, called the bid-offer spread, widens when dealers think they may have to hold the bonds longer. For example, a credit downgrade for a municipality would reduce demand for a dealer’s bonds, triggering an increase in the bid-offer spread or the dealer’s willingness to buy and hold such bonds.

Although municipal bonds can add diversification, investors sometimes unwittingly increase their risk by concentrating in bonds issued by their own state, Latta warns.

Municipal bonds’ relatively safe, tax-efficient income may help investors capture greater after-tax yield without a potentially significant increase in risk. It’s important to note that the sector does present potential pitfalls, which must be managed carefully.

“We may not be facing a sweeping decline in credit quality,” Latta says, “but investors still need to have a firm understanding of the bonds they are considering to make the most of them in any smart financial strategy.”

(A Merrill Lynch Wealth Management Advisor, who can be reached at 410-213-8520.)

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