Four Reasons to Invest in Munis
The municipal bond market has been the subject of some negative headlines in recent months. Analysts and observers alike have been outspoken in their fears, particularly related to the creditworthiness of state and local issuers of municipal debt, who are struggling to balance budgets and regain their fiscal footing in the aftermath of the Great Recession.
"The news flow has not been kind, and the market response has been painful," says Peter Hayes, Managing Director and head of BlackRock's Municipal Bonds group. "But it's important to separate reality from hyperbole, particularly when it comes to making sound investment decisions." Following are four reasons why investors should consider an investment in municipal bonds today.
History of low default rates, even during the Great Recession. A Moody's default rate study released in 2010 found that only 54 municipal issues defaulted during the time period from 1970 to 2009. Compared to corporate bonds, municipals demonstrated lower overall default rates and higher recovery values. The default rate over the past 40 years for investment-grade municipals was only 0.06%, compared to 2.5% for investment-grade corporate bonds. "Some argue that the severity of this recession made it a game changer," says Mr. Hayes, "but we're already seeing promising signs — revenue collections are improving, debt service (as a percentage of expenditures) is low and states are exercising powers to balance budgets and restore fiscal integrity. All of this bodes well for future health."
Tax-exempt income, a feature unique to munis. Municipal bonds are exempt from federal and, in some cases, state income tax. For an investor in the 35% tax bracket, a taxable investment would need to pay more than 6% to outpace (on an after-tax basis) the return of a tax-exempt bond yielding 4%. In the current low-yield environment, where yields on some municipal bonds are exceeding those of their Treasury counterparts before tax, the after-tax income potential is even more appealing. Simply said, munis allow investors to keep more of what they earn.
Attractive income alternative. In an environment where yields are near historic lows for most traditional fixed income options, municipal bonds are looking comparatively attractive. According to Mr. Hayes, "Many investors, particularly those in higher tax brackets, are taking advantage of this opportunity to replace some of their corporate bond exposure (investment-grade and some high yield) with positions in municipal bonds offering higher after-tax yields."
Appealing value given the recent bout of volatility. The municipal asset class experienced a setback in late 2010 and early 2011; the fourth quarter of 2010 was its worst-performing since 1994. Mr. Hayes points out, however, that "sell-offs can be healthy, allowing investors an opportunity to enter the market at attractive levels with the potential for future appreciation." For long-term investors able to bear interim volatility, today's levels may well represent an attractive value opportunity in municipal bonds.
According to Mr. Hayes, "Despite recent headlines, tax-exempt bonds maintain a track record of low defaults and remain an important tool for diversifying a fixed income portfolio and reducing the tax bite on investment income." Given the complexity of today's marketplace, he recommends gaining exposure to municipals through a professionally managed and diversified portfolio. "Munis are no longer a generic asset. Opportunities exist, but careful credit research and selectivity are key."
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