Asher Hawkins

Asher Hawkins, Forbes Staff

11/21/2008 @ 6:10AM

Eeny, Muni, Miny, Moe

In early October California was so short on cash that Governor Arnold Schwarzenegger wrote U.S. Treasury Secretary Henry Paulson warning of yet another entity in need of a federal bailout. Dramatic, even for a Hollywood actor. Within two weeks California had raised $5 billion by issuing notes backed by tax revenue the state will collect in spring 2009. The state had to pay a usurious 4.25% yield on the eight-month paper, triple what the U.S. Treasury pays. This despite the fact that the California paper, but not the T bill, is exempt from federal income tax.

The municipal bond market, in case you hadn’t noticed, is in a state of turmoil. In normal times tax-exempt general obligation bonds from creditworthy states and cities pay somewhat less than U.S. Treasury bonds of like maturity. Investors are willing to accept a lower yield on the muni (and put up with a risk of an early call, a risk almost absent from the Treasury market) in return for the tax exemption. These are not normal times.

The average AA-rated state bond due in 20 years yields 5.3%. That’s 120% of the yield on a 20-year Treasury. For most of the past 15 years the 20-year aa muni average yield has been 88% or less of the corresponding Treasury yield (see chart).

What’s depressing the prices of municipal bonds, and thus forcing up their yields? One big thing is that some banks and insurance companies with mortgage-related losses have been unloading muni bond holdings. But there are four good reasons wealthy individuals, the mainstay of the muni market, have been hesitating to buy.

The first and biggest risk with a municipal bond is inflation, which would soon entail higher interest rates, which would in turn make a low-coupon bond worth less. That’s a risk with Treasurys of long maturity, too, so it doesn’t explain the inverted yield relationship with Treasurys. It’s simply a reason for you not to go whole hog into long-term muni bonds.

To mitigate the risk of rising rates, go short with some of your money. John Miller, chief investment officer at Nuveen, who runs munis for the company, suggests splitting a muni bond fund portfolio 60% to 40% between short or intermediate funds and long-term ones.

Next, early call. If we get deflation instead of inflation, bondholders will want to cling to their 5% coupons, but muni issuers will snatch them away by redeeming the bonds early and refinancing at lower rates (just as homeowners do with their mortgages). Most munis are callable. Most Treasurys are not.

Third is default. This is a distinct risk on so-called revenue bonds, those backed by a project or a private company rather than a government’s taxing authority. It’s a rare but not impossible occurrence on government-backed bonds. In 1994 Orange County, Calif. defaulted, although savers who waited patiently eventually got the cash they were promised.

The fourth hazard is taxes. The federal government counts “tax-exempt” interest in figuring how much of your Social Security benefits are taxable and how much you have to pay for Medicare benefits. Also, the regular income tax hits you up for the portion of your yield that comes from any discount in the price you pay. Finally, the alternative minimum tax nails interest on some revenue bonds. If you are likely to be subject to the AMT, inquire before buying a bond or a bond fund.

Should you buy bonds or a bond fund? A no-load bond fund is a very liquid investment and makes sense unless (a) your portfolio runs to several million dollars or (b) you know you will hold all your bonds to maturity. For a table of some of the best available muni bond funds, go to

Should you go out of your way to buy a fund containing only bonds from your home state, so as to avoid both federal and state income tax? That’s a moot question in eight states that don’t tax any muni interest: Alaska, Florida, Indiana, Nevada, South Dakota, Texas, Washington and Wyoming. If you live in a tax-happy populous state with a lot of choice in bond funds (California or New York, for example), a double-tax-free muni fund can make sense.

Watch those overhead costs. Residents of low-issue states such as Arizona don’t have any cheap single-state muni funds to buy. With the Franklin Arizona Tax-Free Income Fund an in-state investor earning $150,000 a year avoids a 4.5% state income tax. Applied to the 4.75% yield on a national muni fund, that tax costs you 0.21% of your assets annually, or 21 basis points. But you can deduct Arizona taxes on your federal return (unless you pay the AMT). So the tax cost of an out-of-state muni bond shrinks to 14 basis points. Vanguard has national muni funds with expense ratios of only 0.15%. The Franklin Arizona fund runs 48 basis points more, and carries a 4.25% front load. It doesn’t begin to cover this added burden with the tax benefit.


Go Short! (Or Intermediate)

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