Municipal Bonds Still Have the Goods

Perhaps the most pervasive story of 2015 has been the dual threat and promise of rising interest rates. It seems that the time has come for the Federal Reserve to finally start increasing benchmark rates that have been kept at 0% since the Great Recession—this fact has thrown a lot of high yielding sectors for a loop. Investors have plowed some big bucks into everything from utilities to MLPs in order to gain a little bit of yield.

With the Fed now raising rates, many of these sectors have fallen hard over the last few months in anticipation of that rate increase. And yet, for many of these high-yielding sectors, it’ll still be business as usual when Yellen & Company finally pulls the trigger. For forward thinking investors, there can be some big discounts and bargains to be found in these high-yielding sectors.

A prime example could be boring, municipal bonds.

Municipal bonds are issued by state and local governments, and municipalities to fund their day-to-day operations. A local town’s sewer is most likely financed and built via a bond offering. The county clerk’s salary is probably also paid via one. And while there are some exotic styles of munis—such as financing a new stadium for a pro sports team or a monorail system—the vast bulk of them fit into the general obligation category. By nature, they aren’t that exciting.

However, lately, they haven’t been so boring.

Trading volumes in munis have risen recently and volatility has entered a relatively sleepy sector. The immensely popular iShares S&P National AMT-Free Muni Bond ETF (MUB) has quickly become a trading vehicle for the staid sector. The reason comes down to the Fed.

First, interest rate fears have muni investors shaking about when the Fed will actually click the “yes” button. The problem is that most municipal bonds are long dated; there are plenty of munis bonds with maturities in the 30 to 50 year category. Duration risk is a real phenomenon and as interest rates rise, bond prices fall—and those bonds with a longer duration feel the hit harder than shorter ones.

Second, we’ve seen some big time defaults and credit issues within the sector. Normally, standard munis bonds have pretty much a 0% chance of default. After all, any town can just keep raising taxes to pay off the obligation. However, recent issues in Puerto Rico and Detroit’s mega-munis bankruptcy have thrown many munis investors into a tizzy. These are events that generally never happen.

The combination of these two events have woken-up the sleepy sector—but investors should just ignore them.

The reason why investors may want to look at munis in the first place comes down to taxes. The beauty of munis bonds is that they are exempt from Federal taxes and, in some cases, state/local taxes. Tax reforms enacted in the U.S. at the end of 2012 managed to push the top income tax rate to 39.6%. That’s a lot of coin and doesn’t take into consideration the effects of higher dividend taxes and the new 3.8% Medicare tax on unearned income.

This tax advantage gives munis a unique position relative to other bonds, dividend stocks and other income investments. Munis bond funds are often quoted with a “taxable-equivalent yield” that is often a few percentage points higher than similar taxable bonds.

And as we are entering an election year, the truth of the matter is both sides of the aisle have done their fair share of tax increases. There is a pretty good chance that you and I are going to be paying a lot more in the future.

As for the duration problem, it seems that it might not be true.

Given their long shelf life, many munis are purchased by life insurance funds, pensions, endowments and other high net worth investors. The idea is to balance cash flows with investment income. As a result, most munis aren’t traded, and instead held through till maturity. The tax benefits and the steady source of buyers for these bonds have kept prices pretty steady over the long term and in rising rate environments.

With all of this in mind, investors (especially in higher tax brackets) have an opportunity to load up on munis. Investors in the sector should continue to see the benefits even well after the Fed raises rates. All in all, munis are just another example of how perceptions about rising rates have skewered the many sectors.

All in all, the tax benefits will outweigh any near-term damage caused by rising rates. Smart investors may want to add a dose of munis to their portfolios.

Check out Municipal Bonds 101 to understand everything you need to know about municipal bonds.