Muni bonds that won't blow up

chart_munis.top.jpg By Hibah Yousuf, staff reporter


NEW YORK (CNNMoney) -- The municipal bond market is finally starting to recover from a severe winter slump, and some experts say the outlook for state and local government debt is sunnier than ever.

Investors dove out of munis late last year after headlines about looming defaults sparked a heavy sell-off, with some $30 billion being pulled out just between Dec. 1, 2010 and March 31 of this year, according to the Investment Company Institute.

Tax free vs. Taxable
Based on an initial $100,000 investment, investors will generally need higher yields from taxable bonds for the same return.
Tax-free yield Taxable equivalent yield
3% 4.6%
4% 6.2%
5% 7.7%
6% 9.2%
7% 10.8%
8% 12.3%
9% 13.8%
10% 15.4%
Source:Figures based on investors with a federal tax rate of 35%.

Though investors continue to pull money out of the market, redemptions have slowed in recent weeks.

"The fear over a massive wave of impending defaults is overblown and uninformed, but the reality is that state and local government are dealing with deficits, and some issuers are better than others," said Joe Darcy, head of municipals sector at Hartford Investment Management.

Darcy, who manages the Hartford Municipal Real Return Fund (HTNAX), said he's particularly comfortable with tax-backed general obligation bonds issued at the state level, citing a slow but steady return of sales and income tax revenues.

But investors should proceed with caution. States like Illinois and California continue to make headlines over their budget troubles so those may not be the best bets.

"Investors need to be selective, and need to watch out for states with particularly high unemployment, low unemployment growth and the ones that make the news for political budget battles," warned Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management.

On the local level, experts are big fans of revenue bonds issued for essential services, such as electric power, or water or sewer systems, since they provide reliable income streams and are often of high credit quality.

"Whether the economy goes up, down or sideways, people have a need for services like clean water, so people will pay for those essential services," said Darcy of Hartford Investment Management.

That's largely why the BlackRock National Municipal fund (MDNLX) is overweight in bonds secured by essential service tax revenues, said Peter Hayes, the head of BlackRock's municipal bonds group.

Ultimately, the safest bet for investors seeking exposure to munis may lie with mutual funds and exchange traded funds.

"Those types of products pay close attention to credit quality for you and are diversified since they are professionally managed," said Jim Colby, senior municipal bond strategist at Van Eck Global, which offers the Market Vectors family of ETFs that includes the Short Municipal Index ETF (SMB), the Intermediate Municipal Index ETF (ITM) and the Long Municipal Index ETF (MLN).

For mutual funds that boast a mix of highly-rated munis at low expense ratios, Standard & Poor's analyst Todd Rosenbluth recommends T. Rowe Price Summit Municipal Income Fund (PRINX), the Dreyfus AMT-Free Muni Bond Fund (DRMBX) or the Fidelity Intermedial Muni Income Fund (FLTMX).

"We've found that these funds outperform their peers and control risk from both a credit perspective and a duration perspective," Rosenbluth said.

Why munis? The big attraction of muni bonds over Treasuries lies with the tax-free structure. Many munis are exempt from federal taxes and often from state and local taxes as well.

Treasury yields historically outperform muni yields but recently it's been the reverse and that's making munis more attractive.

Treasury yields have been abysmal, as the 'flight to safety' play has pushed Treasury prices sky high and yields very low. The 10-year yield has hovered around 3.5% for months.

"Both muni bonds and Treasuries are considered to be low-risk investments, but the yields on high-quality muni bonds are more appealing in comparison," said Rob Williams, director of income planning at Charles Schwab.

For example, a AA-rated 10-year general obligation municipal bond currently yields a tax-free 3.54%, according to Thomson Reuters' Municipal Market Data. That's on par with the 10-year Treasury note.

But here's where investors win with munis.

Both securities would deliver a $3,500 return, based on a $100,000 initial investment, based on a 3.5% yield.

However, an investor who falls in the 35% federal tax bracket would only get $2,275 because of the tax bill, while a muni investor would get the entire return, free of tax. The taxable bond would need to yield at least 5.4% to match the lower yielding, but tax-free, bond. To top of page

Frontline troops push for solar energy
The U.S. Marines are testing renewable energy technologies like solar to reduce costs and casualties associated with fossil fuels. Play
25 Best Places to find rich singles
Looking for Mr. or Ms. Moneybags? Hunt down the perfect mate in these wealthy cities, which are brimming with unattached professionals. More
Fun festivals: Twins to mustard to pirates!
You'll see double in Twinsburg, Ohio, and Ketchup lovers should beware in Middleton, WI. Here's some of the best and strangest town festivals. Play
Overnight Avg Rate Latest Change Last Week
30 yr fixed3.93%4.15%
15 yr fixed3.03%3.12%
5/1 ARM3.27%3.19%
30 yr refi4.01%4.20%
15 yr refi3.09%3.17%
Rate data provided
by Bankrate.com
View rates in your area
 
Find personalized rates:
Index Last Change % Change
Dow 16,614.81 215.14 1.31%
Nasdaq 4,419.48 103.41 2.40%
S&P 500 1,941.28 37.27 1.96%
Treasuries 2.21 0.03 1.24%
Data as of 5:46pm ET
Company Price Change % Change
Apple Inc 102.47 2.71 2.72%
Bank of America Corp... 16.60 0.34 2.09%
The Coca-Cola Co 40.68 -2.61 -6.03%
Regions Financial Co... 9.26 0.10 1.09%
Micron Technology In... 31.19 1.50 5.05%
Data as of 4:02pm ET

Sections

Yahoo was in the spotlight Tuesday as it released its third-quarter results, its first earnings release since the Alibaba IPO. More

Yahoo was in the spotlight Tuesday as it released its third-quarter results, its first earnings release since the Alibaba IPO. More

Startups focusing on "ag tech," or agricultural technology, are gaining the attention of farmers and investors More

Foreign workers, lured by false promises of good jobs and benefits in America, soon find themselves enslaved in plain sight as victims of labor trafficking, a report from the Urban Institute finds. Here's how it can happen. More

Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.