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The Fall & Rise of Municipal Bonds

Following a recent sell-off and then rebound in municipal bonds, Brian Kilb explains some of the pros and cons of these tax-advantaged fixed-income investments. Brian spoke with Joel Dresang in a Money Talk Video. A transcript follows.

Joel Dresang: Brian, I want to talk with you about municipal bonds, which are tax-advantaged, fixed-income assets. They sold off toward the end of 2016; 2017 started, and they bounced back. Tell me about the sell-off first.

Brian Kilb: Well, first of all, Joel, the whole bond market sold off in November and December. You may recall that in November, the 10-year U.S. Treasury was around 1.5%. By the end of December, up a full percentage point to 2.5%. That’s a huge movement in yield in the bond market, in a short period of time.

So as interest rates rise, the price of your bonds falls. So that price depreciation was felt significantly in the bond market, as we ended the year.

Joel: What was behind that?

Brian: A couple of different things. I think first, anticipating a rise in interest rates as the Fed got about their business of increasing interest rates over a period of time. As it turned out, the Fed raised rates a quarter of a percent near the end of the year. But, again, if bond interest rates moved a full percentage point, the bond market baked in several rate increases into the market in the last couple of months of the year. So, the bond market probably got a little bit of ahead of itself in terms of volatility, in the end of the year.

Joel: But the munis responded even more dramatically than the broader bond market.

Brian: Yeah, I think there’s a couple of things going on there. First, now we have a new administration so we’re starting to anticipate what kind of policy may come of the new administration.

There is some discussion that some taxable interest might not be deductible anymore. There’s some discussion that tax-exempt interest like on the munis might no longer be exempt. Corporate tax reform, individual tax reform, it’s possible that upper-income tax rates might be lower. That would certainly need to be repriced in the muni-bond market.

Joel: So what about the recovery since the beginning of 2017?

Brian: I think it’s more a situation where the bond market realized it got a little ahead of itself.

I think some of the other things in terms of anticipating what fiscal policy might be, people also kind of realize “Hey, the administration’s brand new.” It’s going to take a while to get legislation out there, to pass the legislation and for the impacts to be felt.

So I think it’s more just a recognition of the marketplace that these things are going to happen over a longer period of time and allowed the bond market to breathe a little bit and come back.

Joel:  So considering where we are, what we’re expecting from the Fed, for instance, how do you see munis fitting in most portfolios?

Brian: Well, I think municipals are attractive to folks in higher income tax brackets. Right now, the spreads between taxable bonds and tax-free bonds are around 26%.

So we call that the tax equivalent yield. So, if you’re paying income taxes at 26% or higher, your net yield is better off on the tax-free side.

I also like muni bonds because it’s a different asset class. It’s a different kind of bond than the federal government bond or a different kind of bond than a corporate bond.

So you’re getting exposure to a different type of credit situation. It diversifies your portfolio that way. So I like munis. I like munis for a higher taxpayers, taxpayers that want to be avoid taxable income and for taxpayers that want to diversify their portfolios in other ways.

Joel: What about risks? What are your concerns about munis?

Brian: Well there’s a couple of things unique to munis that you need to pay attention to, Joel. Certain types of municipal bonds, private activity bonds, the interest on those bonds has to get added back in your alternative minimum tax calculation, when doing your tax return.

Another thing to pay attention to, Joel, is whether or not that tax-free income affects your taxation of your Social Security benefits. That can happen from time to time.

I think liquidity is an issue in the muni bond market that you might also keep an eye on. It’s a smaller bond market. If there are big movements, they can sometimes create a greater field of volatility in the markets from time to time.

And then maybe the last thing would be just to make sure you know what you’re buying in the muni bond market. Doing due diligence is a little bit more difficult.

That would speak to mutual funds or other products where you’re getting a little bit of help on the research side to make sure you know what you’re buying.

Joel:  So municipal bonds aren’t in everybody’s portfolio. Remind us, who are the best candidates for these?

Brian: Well, first of all, Joel, remember that they have to be in after-tax accounts, right? They aren’t going to do you any good if they’re in an IRA, because that money is just not taxed until it’s distributed.

I think also higher-income clients are obviously more suitable to take advantage of the tax-equivalent yield of tax-free bonds. And also clients that want to diversify their portfolios with yet another asset class.

There’s a lot of different ways to build safety into your portfolio. And I think well-diversified portfolios are not just well diversified in types of different asset classes, but even within fixed income, all kinds of different choices are there to take advantage of.

Learn more
Investing in Municipal Bonds, a Money Talk Video with Dave Sandstrom
Bonds Also Face Investment Risks, a Money Talk Video with Tom Pappenfus
Municipal Bond Checklist, from the Financial Industry Regulatory Authority

Brian Kilb is chief operating officer and executive vice president at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May and Jason Scuglik

(initially posted March 7, 2017)

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