Municipal bonds have long provided a tax-advantaged investment option for those in higher tax brackets. Their exemption from federal, and often state and local taxes, makes them attractive on a taxable equivalent basis to other fixed income options. However, municipal bonds can be used by investors in any tax bracket to offer a solid, relatively safe by historical standards, return.
Current Environment – The allure of municipal bonds has not been lost on investors as the sector has enjoyed a sustained rally. According to Barclays, the sector was up 9% in 2014 on a total return basis. However, looming concerns about interest rate increases, Puerto Rico and Illinois have torpedoed the market thus far in 2015.
Taxable Portfolio Strategy - As dividends and capital gains are taxed at a lower rate than interest, we usually advise clients to hold, to the extent possible, equity in taxable accounts and fixed income in tax-deferred accounts. Should fixed income be held in the taxable, we recommend municipal debt to bring down the tax liability.
Tax-Deferred Portfolio Strategy – Even in a tax deferred portfolio, municipals can play a valuable role. We advocate placing higher yielding taxable municipals in IRAs, Roths and other tax-deferred accounts. Taxable municipal bonds are often issued to finance a project that does not provide a major benefit to the general public, such as a stadium. As such, the federal government will not provide the tax-exemption. Taxable municipals often have a higher yield than Treasuries, agency bonds and corporates.
Individual Bonds vs. Funds– When purchasing an individual bond you know exactly – absent default – what you will get back at maturity. When bond funds are purchased, capital gains and losses are often outside of your control, determined by the portfolio manager or redemptions of the funds. That being said, it is often difficult to gauge the long-term credit risk of an issuer without substantial research or to buy enough bonds to offer diversification. We recommend sticking with high quality municipal bonds with maturities timed to meet your cash needs. This mitigates credit risk and capital gains surprises. Should you go the fund route, choose a well-diversified and high credit quality fund.
Diversify Your Holdings – The grand mantra of investing should apply to your municipal bond portfolio as well; buy a basket of diversified geographies and issuing entities. While there are concerns about Illinois, Puerto Rico, New Jersey, and California, other states are enjoying a strong economic climate. Balance the higher yields you will receive from California with the lower rates of thriving Virginia, North Carolina, and Georgia.
Watch the Headlines for Credit Issues – The Detroit news of past has now been replaced with concerns about Chicago, the State of Illinois, and Puerto Rico. Chicago debt was downgraded below investment grade status by Moody’s in May, most notably because of the city’s public pension dilemma. Yields on credits of these entities have risen dramatically as a result of the news.
Don’t Feel Compelled to Support Your Home State – Bonds issued by your domiciled state have the advantage of being triple tax-exempt – from federal, state, and local taxes. However, the tax savings may not be worth the risk should something go wrong. We don’t advocate a resident of California loading up on debt in that state. Bonds from states without income tax, such as Florida and Texas, often yield more as an enticement to out of state investors. In addition, U.S. territories such as Puerto Rico and the Virgin Islands historically have also offered debt free from any state or local taxes. However, Puerto Rico is one of the headline news credits right now.
Closed-End Funds (CEFs) Offer Attractive Value – Consider adding CEF’s to your bond portfolio. These funds employ leverage in their structure and also trade at significant discounts – often 10% or more – to the net asset value of the holdings of the fund. Investors can benefit not only from collecting the attractive yield but also from any price appreciation that results.
Note: Elaine Phipps, MBA, CFA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.
Point View Wealth Management, Inc. works with families in Summit and beyond, providing customized portfolio management services and comprehensive financial planning, to develop and achieve their financial goals. We are independent and fee only. How can we help you? Contact David Dietze (firstname.lastname@example.org), Claire Toth (email@example.com), or Elaine Phipps (firstname.lastname@example.org) or call (908) 598-1717 to learn how.