Looking for a Portfolio Boost? Surprise — Municipal Bonds

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[dropcap]I[/dropcap]t was a full year ago that Meredith Whitney took aim at the municipal bond market on 60 Minutes. The Wall Street analyst asserted that the sorry state of public finances amid a struggling slow-growth economy was about to unleash the mother of all default waves among tax-exempt bonds.

So what happened? Not much.

As of Dec. 1, there had been just $1.2 billion in defaults. That’s barely a rounding error in the $2.9 trillion world of municipal bonds. At the same time, we’re one year removed from the recession and though growth remains slow, it’s growth nonetheless. That helps stabilize municipal coffers. And we’ve also seen plenty of states and municipalities step up to the plate to address fiscal issues. Net-net, it’s hard to make an argument for things being worse today than they were a year ago, and yet we had minimal default damage (and the vast majority of defaults were in unrated bond issues.)

Impressive returns

If you were among the spooked investors who high-tailed it out of municipal bonds in late 2010 and 2011, you might be feeling a little remorse right about now. The Barclays Capital Municipal Index has a year-to-date total return of 10 percent. That’s well ahead of the 7.7 percent gain for the Barclays Aggregate Bond index, which is a benchmark for taxable issues.

Moreover, the yield on a high-grade 10-year municipal bond currently exceeds the yield on a 10-year treasury. So even before figuring out the taxable equivalent yield on the muni, you’re already ahead of the game. A pretty decent rule of thumb is that when munis yield as much as 85 percent of what you can get on a comparable-length treasury, the muni should get your attention. Right now we’re over 100 percent:

  • 10-year treasury yield: 1.9 percent
  • 10-year AAA muni yield: 2.0 percent
  • 10-year A muni yield: 2.3 percent

Sure, part of the explanation for the abnormal yield spread is that munis have to offer a higher yield given the default concerns. But what’s also at play here is that the flight to quality has pushed treasury yields so low, it’s making munis look extra enticing.

If you’re in the 28 percent federal tax bracket, that 2 percent on the highest-quality muni works out to 2.8 percent after accounting for the tax break. To get that on a treasury you’d have to stretch all the way out to a 30-year bond, which seems pretty nutty given the low level of all yields today. (Remember, when rates rise — and someday they indeed will — the price of longer-term bonds will take the biggest hit.) And if you are comfy with a solid A-rated muni bond — that’s still part of the investment grade slice — the taxable equivalent yield in the 28 percent tax bracket is 3.2 percent. You can’t get that in any treasury right now, and you might be hard pressed to find that sort of yield among high-grade corporate issues.

Consider the right mix

Municipal BondsSeems like munis ought to at least get your attention as a yield enhancer for your portfolio. If you’re worried about defaults, well, the old advice has never been more apt: Consider a diversified mutual fund that owns dozens if not hundreds of issues. For example, the Vanguard Intermediate Term Tax Exempt fund (VWITX) has a current yield of more than 3 percent, as does the Fidelity Intermediate Term fund (FLTMX). That works out to taxable equivalent yield of 5 percent for anyone in the 28 percent federal bracket. Not bad, eh? Both funds invest in investment-grade issues.

You can of course get even more yield if you opt for a longer-term fund or ETF. But again, in this low-rate world you need to think a step or two ahead. At the point that rates eventually start rising, the longer-term funds will get smacked around harder. Stick with intermediate (or make it the bulk of your bond exposure) and you are getting some treasury-beating yields without taking on undue interest rate risk.

Image used under Creative Commons by Flickr user Fortune Live Media.

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Carla Fried

Carla Fried is a freelance journalist who has covered just about every nook and cranny of personal finance for media including Money Magazine, The New York Times, and CBS MoneyWatch.com. Prior to launching her own reporting and writing business in 2002 she was a senior writer at Money and the managing editor of Quicken.com.

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