Experts Agree Now Not Ideal Time To Jettison Munis

OCEAN CITY — To many investors in higher tax brackets, high credit quality municipal bonds have long represented one of the safest and most reliable sources of tax-efficient income they can own. That’s part of the reason why the recent volatility in the muni market is so unsettling.

With investors reacting nervously to media reports about the mounting budget crises in California, Illinois and elsewhere, municipal bond prices dropped 4.5% in the last quarter of 2010. That may not sound so terrible compared with the volatility that gripped some other investment classes in recent years, but it was the worst quarter for municipal bond performance since 1994, when Orange County, Calif., famously filed for bankruptcy.

Still, the recent news, albeit unsettling, is no reason to abandon your muni investments.

"They remain a vital part of a diversified portfolio," says Thomas Latta, managing director, Investment Management and Guidance, Merrill Lynch Global Wealth Management.

Muni yields are free of federal and typically state income taxes, so their after-tax yields have the potential to outperform other common sources of fixed income. The key in this environment is to be more specific about your choices, says Latta. Know the munis you own, and have a good understanding of the combination of munis that make up your portfolio.

For all the recent concern about issuers not meeting their obligations, outright defaults tend to be extremely rare. This, in part, is because of to the taxing authority of states and local governments, as well as the fact that they’re constitutionally prohibited from carrying over large deficits from year to year. In the past 39 years, roughly 0.1% of all muni debt has defaulted. To put that in perspective, even if muni defaults rose a hundredfold, their default rate would still be below the typical rate of corporate bonds.

However, the municipal bond market is susceptible to posturing by governments, union officials and politicians seeking leverage through the press in budget negotiations. As states and cities move closer to their traditional June budget cycle, notes Christopher J. Wolfe, chief investment officer for the Private Banking and Investment Group, Bank of America Merrill Lynch, "you can expect the negative news to increase and the volatility in muni prices to rise along with it."

Because the muni market has no centralized trading venue, there could be fewer buyers for specific issuances.

More than ever, you should look to higher-quality general obligation (or "GO") bonds and revenue bonds backed by essential services such as power, water and sewer, as these are funded by revenues from sources that are vital to the operation of the municipality.

Also look to higher-quality special project bonds for bridges, toll roads, stadiums and the like. Maturity should be kept in the five- to 10-year range  —  long enough to generate higher yield (as with all bonds, you’re rewarded with higher interest payments the longer you commit to holding the notes) without unduly exposing your portfolio to drastic moves in prevailing interest rates or inflation, both of which can also depress bond prices.

Although bond ladders — a strategy of purchasing bonds that come due at different intervals to provide a steady stream of income over an extended period — have traditionally been a common way of directly holding large blocks of munis, it may be less effective to stick with that strategy in the current environment, says Wolfe. Instead, he says, investors may be better off with a more active approach designed to vigorously sidestep further price drops and "take advantage of the opportunities that are most definitely available in this market."

You should review your holdings frequently, check for higher-quality munis and review your combination to ensure that you are truly diversified. And, as always, you should talk with your financial advisor about the approach that makes the most sense for you.

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