The Anna Maria Island Sun Newspaper

Vol. 14 No. 22 - March 26, 2014

BUSINESS

Anna Maria Island Sun News Story

Municipal bonds may be in sweet spot

Investment Corner

In sports the phrase “sweet spot” refers to the ideal position on the racquet, club or bat to strike the ball in order to get the maximum desired result. In investing, sweet spot refers to the segment of an asset class which may offer the best future return in the foreseeable future. Unlike the physics involved with striking a ball, there are never any guarantees to investment concepts, but looking for sweet spot opportunities can help keep risk in check, and hopefully, enhance returns.

The area I’d like to review is the segment of the fixed income markets known as municipal bonds. The interest paid on municipal bonds is free from taxation by the federal government, so these securities are also called tax-free bonds. Municipal bonds are issued by state, county and city governments to help fund projects ranging from water and sewer facilities to building roads or municipal buildings.

The tax free nature of the interest paid on these bonds makes them attractive to investors, particularly those in the top tax brackets. Historically, these bonds pay a lower rate of interest than a comparable quality bond issued by the federal government or a corporation. In other words, investors don’t demand as much yield on their investment if the income is not taxed.

So, with 10-year U.S. Treasury bonds currently yielding around 2.7 percent, you would expect to see high quality municipal bonds yielding around 1.9 percent, or about 30 percent less yield to account for the tax-free nature of the income. Historically, this has been the case, but things changed starting in the 2008-2009 financial crisis. With some high profile municipal bankruptcies in recent years such as Detroit, Mich., Stockton, Calif., and Jefferson County, Ala., striking fear into the hearts of municipal bond buyers, we now have an inverted yield comparison.

Instead of municipals yielding less than comparable federal or corporate bonds, they are yielding the same or more and still offer the tax-free advantage. So, currently, the average high quality municipal bond is yielding around 2.7 percent, the same level as a 10-year treasury bond. But, with the income being tax free that’s the same as earning 4.2 percent on a taxable bond for an investor in the 35 percent tax bracket.

The difference becomes more pronounced if we start dipping down the quality scale a bit. High-yield bonds pay higher levels of interest because the issuer is not as financially strong. High-yield municipal bonds presently reward investors with 6.8 percent average yield. That’s the same net yield as earning 10.4 percent on a taxable bond!

So, what about risk? Obviously municipalities don’t print money like the federal government, so we cannot assume the same level of guarantee of return of principal that you would have with a treasury bond. By using a mutual fund specializing in high quality or high yield municipals, you can gain instant diversification across hundreds of issuers. If one filed for bankruptcy, the impact on the portfolio would be minimal. For most investors, I believe a mutual fund or exchange traded fund is the correct vehicle to obtain management expertise and diversification.

With virtually every other fixed income investment category fully valued at present, municipal bonds offer compelling yields and the potential for moderate price appreciation.

Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.

 


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