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Many brokers recommend investing in municipal bonds. Municipal bonds, a.k.a. munis, are a debt security issued by a state, municipality or county to finance its capital expenditures. Most are exempt from federal taxes and even state taxes if you live and file taxes in the issuing state. They are often pitched as being very safe with a long history of low default rates.
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So what’s not to love about safe, tax-free income?
Well, here are four reasons to at least limit your exposure to munis. And, in my view, the fourth is the mother of all reasons.
- Your income may be an illusion. I have some investors who tell me their income from a muni bond portfolio is far higher than that of a muni bond mutual fund. And they also tell me that their broker says the municipal bond market is an inefficient market, so it’s easier for brokers to find higher-paying bonds with no more risk. My heart sinks because I know I have to expose a very costly illusion to them. The illusion is that much of that income is actually only a return of their own principal. While this a bit oversimplified, say the investor buys a bond at $110 with annual income of $4. The brokerage statement shows 3.64 percent income ($4/110). What the brokerage statement doesn’t show is that, in this example, the bond will either mature or be called in five years at a price of $100, or $10 less than the purchase price. That amounts to $2 a year, leaving only $2 in true income or 1.82 percent. It’s even worse if you are paying a management fee. The investor is typically quite upset when I explain it and often responds with something like “Why is this legal?” I’ve never had a good answer.
- Muni bonds are fairly illiquid. Though you can sell them at any time, an important factor of liquidity is how much it will cost you to buy and sell. I call it the industry’s dirty little secret. When someone sells a muni bond, it typically goes to one or more dealers before getting to the ultimate buyer. The difference in price can easily be 1 to 2 percentage points, and I once saw a spread of 10.25 percent. So the commission to buy and sell is peanuts compared to these spreads. The Municipal Securities Rulemaking Board (MSRB), which regulates munis, has a new price discovery tool to help investors understand these spreads, but you must first be aware they exist.
- Munis may now be tied to the stock market. Over the long run, if stocks do poorly, there could be systemic defaults on munis. That’s because states and municipalities have huge liabilities for pension and retiree health care benefits. The money in those pension funds is invested mostly in stocks and bonds. This risk issue was recently examined in a new paper issued by Northern Trust. I spoke with one of the authors, Adam Shane, the firm’s director of fixed-income research. He told me he had seen estimates of unfunded pension liabilities alone amounting to $2 trillion to $4.5 trillion, roughly the size of the $3.7 trillion muni bond market. That is to say, the amount they owe is much greater than the amount they have funded. And that shortfall assumes that overall returns of the pension funds average about 7.5 percent annually, which I think is overly optimistic. Thus, if stocks and bonds don’t have a stellar next decade, that shortfall would widen greatly as baby boomers retire, possibly creating more systemic defaults. Shane told me he thought I was “overstating the risk a bit” and that states and municipalities could mitigate the risk by increasing contributions and renegotiating the liabilities.
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I’m certainly not trying to create a panic. Though I do own a low-cost muni bond fund, it’s a very small part of my fixed-income portfolio. Muni bonds represent about 10 percent of the U.S. investment-grade bond market and I recommend not having more than twice that percentage in anyone’s portfolio. Buying a low-cost muni bond fund through firms like iShares or Vanguard will avoid both the income illusion and the illiquidity issues mentioned earlier. And make sure you have used your tax-deferred accounts to buy taxable bonds and CDs before considering muni bonds at all.
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