Rewards May Exist In Muni Bonds

By Charles Rotblut, CFA, AAII

Worries about state and local government debt continue to drive money out of municipal (aka “muni”) bond funds. The Investment Company Institute (ICI) calculates that muni bond funds incurred $2.4 billion worth of outflows last week. This was the 10th consecutive week of outflows. Since the week of November 10, cumulative outflows have exceeded $25 billion.

(The ICI monitors inflows and outflows for more than 95% of mutual fund assets. The data reflects portfolio changes for both individual and institutional investors.)

The outflows reflect concerns over fiscal problems at state, county and local governments. Declines in tax revenues caused by a weak economy combined with stretched budgets are the primary culprits, as you know. A lack of effective budgeting and planning is compounding matters for certain government entities. These are the factors that often make the headlines when muni bonds are discussed.

What doesn’t make the headlines is the simple fact that municipal bonds vary greatly. Even within a particular state, there can be big differences in the credit quality of municipal bonds. This is why fears about the possibility of defaults are not an excuse for ignoring the entire asset class. In fact, it is possible that some muni bonds are trading at attractive yields relative to their credit quality. (InvestinginBonds.com displays yield indexes by state and has other useful quote information about muni bonds.)

The difficult part is that researching individual municipal bonds takes time and effort. You have to know what revenue stream is tied to the bond and what safeguards exist for investors. For example, is it a general obligation bond or is it tied to a specific tax or revenue stream?

You also have to assess the fiscal strength of the government entity behind the bond. Even if a state is encountering budget problems (and many are), it may still remain far from default. Then there is the fact that not all municipalities use generally accepted accounting rules (GAAP). This means that not all financial statements are standardized. (The decision to follow or not to follow GAAP often comes down to cost and available staffing.)

The payoff for putting up with these hurdles is a potentially higher tax-adjusted yield. (Muni bonds offer tax advantages over other types of bonds and are most beneficial when held in a taxable account.) You may have to dig, but short-term fears can create opportunities for those who are astute and selective.

Buying municipal bonds is more complex than buying stocks, especially since government entities can have bonds with varying maturities and yields. Liquidity also varies widely.

It can be done, however, often through the same broker you are using for trading stocks. (Check with your brokerage firm.) A 2008 article in the AAII Journal, How to Buy Individual Bonds: A Fixed-Income Toolkit, provides suggestions on how to get started.

THE WEEK AHEAD

Earnings season will kick into high gear next week with, more than 120 S&P 500 members reporting. Included in the group are several Dow Jones industrial average components. American Express (AXP) and McDonald’s (MCD) will report on Monday. 3M (MMM), DuPont (DD), Johnson & Johnson (JNJ), The Travelers Companies (TRV) and Verizon (VZ) will report on Tuesday. Boeing (BA) and United Technologies (UTX) will report on Wednesday. Caterpillar (CAT), Microsoft (MSFT) and Procter & Gamble (PG) will report on Thursday, and Chevron (CVX) will report on Friday.

The week’s first economic reports will be the Conference Board’s January consumer confidence index and the November S&P/Case-Shiller home price index, both of which will be released on Tuesday. Wednesday features December new home sales. December durable goods orders and the November pending homes sales index will be published on Thursday. Friday features the first estimate of fourth-quarter GDP and the University of Michigan’s final January consumer confidence survey.

The Federal Open Market Committee will hold a two-day meeting starting on Tuesday, with a statement published on Wednesday afternoon. No change in Federal Reserve policy is expected to be announced.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

Charles Rotblut, CFA is a Vice President with AAII and editor of the AAII Journal.

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