Over the past couple of years, the economic picture has brightened for many cities and states — but some of them are still facing potential financial problems. As a citizen, you may well have concerns about these issues. And as an investor, these financial woes may affect your thinking about one particular type of investment vehicle: municipal bonds.
Specifically, given the difficulties faced by a few municipalities, should you consider adding “munis” to the fixed-income portion of your portfolio?
It is true that municipal defaults, though still rare, rose in 2012. But we haven’t experienced any sharp increases in defaults in 2013. Overall, default rates for municipal bonds are low — much lower than for corporate bonds of comparable quality, according to Moody’s Investor Services.
Of course, there are no guarantees, but if you stick with “investment-grade” municipal bonds — those that receive the highest grades from independent rating agencies — you can reduce the chances of being victimized by a default. And municipal bonds offer these benefits:
- Tax advantages — Municipal bond interest payments are free from federal taxes, and possibly state and local taxes, too. (However, some munis are subject to the alternative minimum tax, as well as state and local taxes.) This tax treatment means you would have to earn a much higher yield on other types of bonds to match the “taxable equivalent yield” of municipal bonds.
- Civic benefits — By adding quality municipal bonds to your portfolio, you can help support worthwhile projects in your community, such as construction of schools and hospitals.
- Steady income — Barring a default, you will receive a regular, predictable income stream for as long as you own your municipal bonds. However, if you currently own many long-term munis, you may want to consider reducing your overall position. Eventually, rising interest rates will push down bond prices, and long-term bonds carry added risk because their prices will decline more as interest rates rise. Work with your financial advisor to determine the most appropriate approach for your situation.
- Diversification — Municipal bonds can help you diversify the fixed-income portion of your portfolio if it’s heavily weighted toward corporate bonds. And you can even diversify your municipal bond holdings by building a “ladder” consisting of munis of varying maturities. Once you’ve built such a ladder, you can gain benefits in all interest-rate environments — when rates are low, you’ll still have your longer-term bonds working for you (longer-term bonds generally pay higher rates than shorter-term ones), and when interest rates rise, you can reinvest the proceeds of your shorter-term bonds at the higher rates.
Consult with your financial advisor to determine if municipal bonds can be an appropriate addition to your portfolio, as investing in bonds involves risks, including credit risk and market risk.
Bond investments are also subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease, and the investor can lose principal value if the investment is sold prior to maturity.
Investors should evaluate whether a bond ladder and the securities held within it are consistent with their investment objectives, risk tolerance and financial circumstances.