Why Invest In Low-Yielding Muni Bonds

June 28, 2016

by Stan and Hildy Richelson

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Shocker! Analysts and investors, who have spent much of the post-crisis period (2009-2016) predicting an upward spike in U.S. and global interest rates, are still wrong! It is now 2016. Investors and analysts are still waiting for the predicted rise in interest rates. The question they should ask is how low yields will go.

A lead article[1] in the June 6 The Wall Street Journal titled “Latest Hot Buy: Municipal Bonds”[i] explains why muni bonds are currently such a desirable asset class. We summarize this important article and provide our comments below.

Why muni bonds?

Investors currently have a number of concerns, including the following:

  • Safety and stability. Equities and junk bonds have been volatile this year.
  • Global growth has slowed, creating more risk in many asset classes.
  • Negative yields on government bonds worldwide.
  • The weak jobs reports, which raises the possibility of a recession.

Investors are taking money out of equities and other risk assets and pouring more money into municipal bonds. Munis are relatively stable and serve as a haven to offset the volatility of equities and junk bonds. Many munis are considered nearly as safe as Treasury bonds. Yet buying municipal bonds, or any bonds for that matter, requires that you commit funds for a number of years. This has been made easier by the following factors:

  1. Due to the last jobs report, interest rates may stay lower for longer than previously anticipated.
  2. Compared to the low world-wide interest rates, many of which are turning negative, yields on munis are relatively appealing.
  3. Muni interest income is generally free of federal income tax and sometimes free of state and local taxes. Munis have recently yielded more than Treasury bonds.

Here is the conclusion of the Wall Street Journal article: Despite munis being at all time low yields and defaults on Puerto Rico and other muni bonds, the risks associated with munis “seem mild compared with the year’s swings in stocks and other risker assets.” Despite the possibility of losses due to increasing interest rates, “…few are predicting a major pullback in munis this year” particularly due to the current low issuance of munis and the relatively high yield of munis compared to interest rates in the rest of the world.

The principal risk to investments in high-quality munis is interest rates spiking in the near term. However, many analysts are concerned with just how low yields can go. Some are predicting that the yield on 10-year Treasury bonds could fall to 1% or below, especially if the U.S. economy loses momentum and heads into recession. Others say yields will rise when inflation appears.[2] In other words, we are in a situation, once again, where we know that we don’t know what will happen.

Advisors should ameliorate the risk of rising interest rates through the following strategies:

  • Use custom bond ladders of individual muni bonds taking into account each client’s cash needs. A ladder will smooth out high interest rates and low interest rates.
  • Focus on cash flow rather than mark-to-market gains and losses. Bonds are the only asset class that is self-liquidating, meaning that they repay their face value at their due date. No other asset class provides this feature. If you buy a tax-free muni bond, no matter how interest rates and the prices of the bonds may vary over time, the face value of your bond will be returned to you at the due date with tax-free income every 6 months. Current cash flow can be enhanced by buying high coupon bonds selling at a premium to face value.
  • Individual investors always ask and need to know how much cash flow their portfolio will return to them over time. Muni bonds are in a unique position to answer this question. They pay interest every six months.

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Muni Bonds