NEW YORK (CNN/Money) -
How safe are single-state municipal bond funds? If I invest in these now during this down market, will they hold their value if stocks pick up again and interest rate rise?
-- David, Ithaca, New York
Over the last couple of years, we've seen many investors flock to bond funds because they seem them as a safe haven from the equity markets. And while bonds can offer some shelter from the falling stock market -- as they've done over the past two years -- it's also important to realize that bond funds, including single-state municipal funds, also have risks.
You've asked specifically about interest-rate risk -- that is, the chance of losing principal if interest rates rise. But there's another type of risk as well, namely, credit risk, or the risk of default.
Let's take credit risk first. When you buy a bond, you are relying on the bond issuer's promise to make timely interest payments -- typically every six months -- and to repay principal when the bond matures, which can be anywhere from a few years to as long as 30 years. If for whatever reason -- economic setback, bankruptcy, whatever -- the issuer can't make those timely payments, the bond goes into default.
That doesn't usually mean the bond is worthless because there may be any variety of assets backing up the bond. But the bond's market value can drop precipitously, often 40 percent or more, depending on what bond-market investors believe are the odds of the issuer eventually making good on some or all of its promises.
When you buy a bond fund, you can mitigate credit risk quite a bit because the fund manager typically picks a diverse group of bonds, that is, ones offered by many different issuers. This is true, for example, if you buy a national muni bond fund that owns issues of many states.
But a single-state muni fund is by its nature not diversified; it owns bonds of only one state. If the state's economy suffers a setback, chances are that the market values of all or most of the bonds in the portfolio will take a hit. That makes single-state funds somewhat more risky than national muni bond funds. Of course, the reason many investors take on this extra risk is that single-state funds provide an extra benefit: the interest they pay is exempt not only from federal taxes, but state levies as well.
Then there is the risk you've asked about -- interest rate risk. When interest rates rise, bond prices fall. I don't know if interest rates will rise over the next year or so. I would expect that to happen as the economy begins to improve. But how long this process might take and how high rates might go, I have no idea.
But if rates do rise, any bond fund, single-state muni or not, will drop in value, the only question is by how much. That depends largely on the maturity of the bonds in the portfolio. In general, the longer the maturity of the bonds, the greater the damage when interest rates rise. So if you own a long-term single-state muni fund -- one with bonds that, on average, mature in, say, 15 years -- the hit to principal if rates rise will be greater than if you own an intermediate-term single-state muni fund with an average maturity of, say, seven years.
The reason longer-term bonds suffer more when rates rise is that investors are locked into low interest rates for a longer time than owners of intermediate-term bonds. So the principal values of the longer-term funds must drop farther to reflect the loss in value of those long-reaching subpar payment streams.
Evaluating the risks
So how do you evaluate these risks? Well, generally, the longer the maturity, the riskier the bond. But maturities serve as only a rough proxy for interest-rate risk. Duration, a technical measure that takes into account the flow of payments from a bond, is a much better gauge. The higher a bond's duration, the more sensitive it is to interest-rate movements.
If a bond fund has a duration of, say, eight years, its price will decline a bit less than 8 percent if interest rates rise by one percentage point, and a bit less than 16 percent if rates jump by two percentage points. The price of the same bond would rise a bit more than 8 percent if interest rates fell by one percentage point and a bit more than 16 percent if rates jumped by two percentage points. Problem is, it can be difficult to get a bond fund's duration, although some fund companies do provide it (and it certainly doesn't hurt to ask).
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The other way to evaluate the riskiness of a bond is to get a free Morningstar QuickTake Report on your single-state funds. If you go to the Ratings and Risk section of the report, you will find a slew of risk and volatility stats that can help you evaluate the overall riskiness of your fund.
Two final suggestions: First, while I have no problem with investors buying single-state muni funds -- especially high-income investors who live in tax hells like New York, California and Massachusetts (or Taxachusetts, as I prefer to call it) -- I wouldn't make such funds my sole bond holding.
I would make national muni funds the core of the bond portion of my portfolio and, depending on my tax bracket, even consider adding some taxable bond funds to the mix, say, governments or high-quality corporates, although I would hold these, if possible, in tax-advantaged accounts.
Second, since it would appear that interest rates are more likely to rise substantially from here than fall substantially, I would be more inclined to stick to short- to intermediate-term funds. All in all, I think what you gain in principal security outweighs the little bit you give up a bit of yield.
Walter Updegrave is the author of "Investing for the Financially Challenged" and can be seen regularly Monday mornings at 8:40 am on CNNfn.