Did your Dad or Grandpa ever talk to you about investing in municipal or tax-exempt bonds? If so, they probably talked about picking individual municipal bonds and holding them to maturity to ensure a steady, tax-free return.
Unfortunately, most of what they told you is about as relevant today as rotary phones and TV antennas.
The banking meltdown of 2008 turned the entire municipal market on its head. Now, investing in tax-free or municipal bonds is fundamentally different from how it was prior to the Great Recession.
To navigate today’s markets successfully, you have to learn a whole new set of rules.
But here’s why it pays off. The tax-free bond market is still a great place for investors in higher tax brackets to look for tax-free income.
The end of insurance
Here’s one of the biggest changes of all.
Before 2007, the municipal bond market was a pretty safe and predictable place to invest. Over 70% of all municipal bonds were insured, guaranteeing that individual investors would be paid back in the rare event of a default. This backstop “insurance” gave the insured bonds a “AAA” rating (the best available) even if the actual state or municipality issuing the bond had a less than perfect balance sheet.
Unfortunately, this cozy world of guarantees and insured returns all started to fall apart in 2007. As real estate and mortgage markets slid into a death spiral, the insurance guarantee companies were dragged down with them.
By late 2009, the portion of the municipal bond market boasting the top “AAA” ratings (often due to insurance) dropped from 70% of bonds to just over 10%.
This was a devastating blow for individual investors. Many bonds lost their insurance, meaning instant downgrades from the top “AAA” rank to ratings further down the quality ladder.
Suddenly, the municipal bond market became a much more difficult place. Investors could no longer count on pristine “AAA” ratings thanks to bond insurance. Municipalities could only attract investors based on the attractiveness of their own balance sheet and credit rating, and in-depth research on the financial statements of every single bond issuer became a critical prerequisite to investing.
The new rules of investing
Today’s marketplace is definitely not your Grandpa’s muni bond market. Gone are the days when you could plunk down thousands of dollars on one bond, from one municipality, or even one state, and hold it until maturity.
The decline of the individual bond: Since 2008, it makes much more sense to buy a managed portfolio of municipal bonds rather than buy individual muni bonds, like Grandpa did. There are several reasons for this change. First, with an astonishing 46,000+ of bond issuers in the Barclays Municipal Bond Index, it’s virtually impossible for individual investors to perform the in-depth credit analysis needed to navigate the marketplace. It makes much more sense to have a dedicated team of experts on your side.
Limited liquidity: There is often limited liquidity in the market, meaning it’s not easy or cheap to buy or sell munis at the drop of a hat. If you do own an individual bond, and need to sell in a hurry, you may not get any takers, or may have to settle for a deeply discounted price. Experienced and full-time traders have the capacity to trade or sell bonds faster and at better prices. When you trade an individual bond, you get much less attractive “retail” prices.
Topsy-turvy G.O.s. G.O.s, or General Obligation bonds, used to be at the top of the muni food chain. They were considered to be the safest bonds, backed by the full taxing power of the issuing municipality. Now, many professionals prefer a revenue bond over a G.O., questioning the ability and the political will of municipalities to raise taxes. Revenue bonds are backed by the income stream from a specific project, which often makes them easier to quantify and understand.
How to tame the municipal market
There are many reasons for higher-tax bracket investors to want a piece of the municipal bond market. Most municipal bonds still offer very good credit quality and tax-free income, and can result in more after-tax income to the investor. But how to navigate such a vast and diverse market?
The solution is to put aside the old model of buying a few individual bonds and holding them to maturity. The new model calls for holding a broader portfolio of bonds to provide diverse geographical, sector and interest rate exposures. Using a fund or ETF in lieu of holding individual bonds provides professional credit analysis and deeper trading resources, at institutional prices.