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Muni Bonds May Show Gains As Tax Increases Approach

With almost all tax rates on income and investments set to rise sharply in 2013, municipal bonds—and the tax-free interest income that most of them generate—are attracting more and more attention from investors.

Most tax cuts legislated in 2001 and 2003 are scheduled to expire at the end of this year. As a result, the top tax rate on ordinary income will jump from 35% to 39.6%, and lower tax brackets also will be adjusted upward. Long-term capital gains, which had been taxed at 15%, will be subject to a 20% levy, and most dividend income, which also had a 15% tax rate, will be treated as ordinary income. In addition, many wealthy investors will be subject to a new Medicare surtax of 3.8% on investment income. 

Against that backdrop, municipal bonds may look particularly appealing. The income munis provide generally isn’t taxable on federal returns (and sometimes also is exempt from state taxes). Moreover, interest on munis isn’t subject to the Medicare surcharge. And, indeed, demand for municipal bonds has been increasing, a trend that Lipper analyst Tom Roseen believes will continue. “Unless something happens by the end of the year, the Bush tax cuts will go away, and people have been thinking about that,” Roseen says.

The popularity of municipal bonds took a hit in 2010, after banking analyst Meredith Whitney predicted a wave of defaults by munis’ state and local issuers. But that didn’t happen, and investors again have embraced the tax-free bonds. “We’ve been seeing consistently strong flows [of investment dollars into municipal bonds] for a year, and I see that continuing,” Roseen says. 

Yet new concerns about the safety of municipal bonds may be coming to the fore, thanks to a recent report by the Federal Reserve Bank of New York showing there have been far more muni bond defaults than most investors realize. While that doesn’t mean investors should shy away from this arena, it does underline the need for expertise and the ability to monitor the muni market. 

Individual investors account for about half of the $3.7-trillion U.S. municipal bond market—or 75% if you include munis held in mutual funds. These investors are attracted not only by the bonds’ tax-free status but also by their relative safety—a factor that some investors may overestimate, according to the New York Fed study. “Although the low default history of municipal bonds has played a key role in luring investors to the market, frequently cited default rates published by the rating agencies do not tell the whole story about municipal bond defaults,” New York Fed officials wrote in a recent summary of the report.

New York Fed officials created a wider database, combining muni bonds rated by the big three ratings agencies—Fitch, Standard & Poor’s, and Moody’s—with unrated listings. The results show far more muni bond defaults than revealed by the big three agencies. In fact, “rather than confirming Moody’s 71 listed defaults from 1970 to 2011, our database shows 2,521 defaults during this same period,” the New York Fed officials wrote. “Similarly, our database indicates 2,366 defaults from 1986 to 2011 versus S&P’s 47.” 

Those huge discrepancies reflect the fact that muni bond issuers tend not to seek ratings if their bonds aren’t likely to achieve investment grade, the New York Fed says. 

Those differences also put a premium on understanding the entire muni landscape. “Different types of municipal bonds are secured by very different revenue sources with varying levels of predictability and stability,” according to the New York Fed, which also notes these other factors that make choosing the right municipal bond a complex undertaking:

  • The municipal market is divided between general obligation (GO) bonds and revenue bonds. GO bonds carry the full faith and credit pledge of a state or local government that can levy taxes. Revenue bonds, however, are backed only by a pledge of revenues from a specific enterprise, such as an airport, toll road, hospital, or school. So GO bonds tend to be stronger.
  • Among revenue bonds, default risks vary based on how essential a service may be—and in that regard, water and sewer utilities tend to have a stronger ability to raise revenue than do pollution control facilities, for example.

 

At a time when pending tax increases make municipal bonds especially alluring, we can help guide you through the complications of the muni market. We offer you the expertise needed to monitor and evaluate municipal bonds and find the right ones for your portfolio.


This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.



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