The Safe Way to Invest in Municipal Bonds

Long a mainstay of conservative income-seeking portfolios, municipal bonds usually sport higher yields than US government debt. Moreover, these issues have a significant tax advantage: The interest paid on these securities is generally exempt from federal levies.

A history of low default rates also contributes to the appeal of municipal bonds, though Detroit’s high-profile bankruptcy provided complacent investors with a reminder that the space isn’t without risk. And unlike when New York City declared bankruptcy in the 1970s, the federal government didn’t come to Detroit’s aid; elected officials will need to work out their own deal with the Motor City’s creditors.

Make no mistake: Other municipalities could follow in Detroit’s footsteps.

But with borrowing rates still low and investors clamoring for yield, state and local governments are on pace to issue a record number of bonds this year. Many of these offerings will refinance high-cost debt issued in past years. But a significant proportion of these new issues aims to plug persistent budget deficits that reflect an anemic and uneven economic recovery.

Individual investors have increased their holdings of these fixed-income securities by 22 percent since 2001 and now account for a record $617 billion of this $1.8 trillion market. As long as investors continue to pour money into municipal bonds at the fastest rate since 1987, the day of reckoning for even the most profligate state and local governments will be forestalled.

However, individual investors are a notoriously fickle lot that’s prone to panic; the Federal Reserve’s plan to phase out quantitative easing could prompt capital to flee the sector, which would increase borrowing costs and heighten default risks among strapped local and state governments. That a major city declared bankruptcy despite salutary conditions for municipal bond issuance underscores this concern.

A Stitch in Time

Don’t get me wrong: I’m not calling for the implosion of the municipal-bond market. Despite the desperate straits in which some governments find themselves, the majority of issuers will be able to meet their payment obligations. Investors also have plenty of choices that offer solid, tax-advantaged yields without the risk of getting stiffed.

However, investors that hold municipal bonds should review their holdings before conditions become more challenging. Take a hard look at the source of the cash from which the issuer pays the interest on the municipal bonds in your portfolio.

Many investors build their municipal-bond portfolios purely on the recommendations of their brokers. This strategy isn’t inherently flawed–as long as either you or your advisor are minding the store. Moreover, buying securities that are in stock often gets you the best buys in the fixed-income segment, which is far less liquid than equities markets.

As long as the market remains receptive to new issues and conducive to refinancing, the majority of municipalities should avoid default. And if you’re not sure what you own, now is the time to research potential problems; don’t wait until the market tightens and liquidity constraints make it difficult to swap out of a floundering position.

Unfortunately, publicly available information on the financial health of government agencies isn’t as robust as the reams of data on corporate profitability. And as we’ve seen time and time again, credit ratings seldom provide sufficient warning when a crisis is brewing.

Consider Orange County, Calif., which in the mid-1990s, commanded an AAA credit rating and boasted a wealthy population. Credit raters were just as unaware as ordinary investors that Robert Citron’s financial schemes had bankrupted the county government.

Although the resulting default didn’t roil the municipal-bond market, the lesson bears repeating: A lack of quality information means that disaster can strike quickly with little to no forewarning. Investors should also be on the lookout for the possibility of selective defaults in certain areas, as politicians opt to stiff bondholders instead of raising taxes to pay the bills.

Understanding how the issuer generates the revenue to pay a particular municipal bond’s coupon can help you to avoid potential defaults. For example, does the cash flow come from a specific project where the interest payment is walled off from political machinations? Does the government entity in question have an established track record of paying interest through thick and thin, regardless of which political party holds sway?

Looking into local politics in the municipalities that issued your bonds should tell you a lot about the credit quality of your holdings. Also, don’t hesitate to ask your broker or a trusted financial adviser about the relative safety of your nest egg. The most important thing is to get a handle on the bonds that you own.

Fund Favorite

You should also consider swapping your holdings of individual municipal bonds for a first-rate mutual fund; we’re partial to Vanguard Intermediate-Term Tax-Exempt (VWITX, 800-662-7447), which sports a low expense ratio and proved its ability to weather tough times in the late 1970s and early 1980s. The fund yields 3.12 percent, requires an initial investment of $3,000 and has about $36 billion in assets.

The chief advantage of gaining exposure to this asset class via a fund is that professional money managers do the due diligence for you. Vanguard Intermediate-Term Tax-Exempt owns a plain-vanilla portfolios composed of high-quality, low-duration securities that have less exposure to interest rates than longer-dated issues.

The fund’s scale keeps expenses low, ensuring that you keep more of your earnings. And this offering doesn’t rely on leverage to juice returns. Management keeps about 2 percent of the fund’s investable assets in cash to cover potential redemptions.

Equally important, Vanguard Intermediate-Term Tax-Exempt posted an annual loss only once over the past decade; the fund gave up 0.14 percent of its value in 2008, compared to the 8.17 percent loss averaged by its peers. 

Source: Bloomberg

Like all bond funds, Vanguard Intermediate-Term Tax Exempt is effectively a black box–you trust management to stick to its proven, low-risk investment strategy. Although the fund’s approach won’t make you rich, management’s expertise and a diversified portfolio–the 10 largest holdings account for only 2.92 percent of investable assets–will ensure that you avoid any major blowups.

In our estimation, this peace of mind is a fair trade-off for a slightly lower yield than those offered by riskier funds or a self-selected portfolio of individual municipal bonds.

Although the fund’s net asset value has declined slightly since interest rates started to rise in early May, management’s focus on near-term maturities should ensure that the yield keeps pace with increasing rates. Vanguard Intermediate-Term Tax-Exempt is one of our favorite mutual funds for capital preservation, steady income and low-risk returns over the long haul.