Many investors preparing for retirement have become concerned about the drop in market value of municipal bonds and funds in 2008 and 2009. Let’s take a closer look.
Historical Benefits of Municipal Bonds and Funds
Before Mr. GoTo discusses the likely reasons for the muni swoon, let’s first review the features and historical benefits of municipal bond funds as part of a baby boomer’s investment portfolio.
Munis were generally out of favor in recent years because their yields, although tax free, did not compare favorable with other low-risk investments, including money market funds, CD’s and Treasury funds. That changed in late 2007 and into 2008. For example, in September 2008, the tax free trailing yields on two low cost muni funds, Vanguard Long-Term Tax Exempt (VWLTX) and Vanguard Long Term U.S. Treasury (VUSTX), moved to 4.62% and 4.56% respectively. That is equivalent to a taxable yield of 6.4%. Very nice it was, particularly considering that the net asset value (NAV) of the funds were relatively stable. At that time the average default rate of high quality municipal bonds was only 0.01%, presenting a negligible risk.
In states with high state and local income tax rates, non-diversified municipal bond funds can be found (i.e., holding bonds issued only in your state) which are also exempt from state and local taxes.
Municipal bond fund investors do have to be careful about the Alternative Minimum Tax which can cause muni bond interest to become taxable. That is why some municipal bonds (e.g., high yield housing bonds) were given favorable tax treatment under the Economic and Housing Recovery Act of 2008. The Alternative Minimum Tax (AMT) will not apply to their interest payments. Thus, you can buy a muni fund that owns only non-AMT bonds, such as the T. Rowe Price Tax-Free Income Fund (PRTAX).
What Happened to Muni Bond Funds?
This brings us back to the last quarter of 2008, when the market values of muni bond funds have fallen dramatically. Why did this happen? This is Mr. GoTo’s take on the matter:
1. Many balanced funds, institutional investors, and hedge funds holding municipal bonds and muni funds were forced to sell them to raise cash and to respond to investor redemptions when the market dropped.
2. Many individual investors panicked and sold everything and went to 100% cash, depressing the values of all mutual funds, including muni funds.
3. Investors recognized that with falling state revenues and a tightening of the credit markets, the risk of default on municipal bonds had substantially increased. This risk perception was particularly damaging to non-diversified muni funds, such as those holding munis issued exclusively in California or New Jersey.
4. Many muni funds invest primarily in “long bonds” i.e., bonds that are not payable for 10-15 years or more. Investors recognize that long bonds are subject to an interest rate risk that is going up rapidly as the government is running such high deficits. This will eventually cause interest rates to increase, thereby devaluing bonds in general. Muni funds holding short to medium term bonds should do better.
5. Some muni bond funds invested in insured bonds. (An insured municipal bond is one in which re-payment of interest and principal is guaranteed by a bond insurer.) Bond insurance is sometimes employed by a bond issuer to increase the marketability of the bond. In 2008, three of the six primary insurers were downgraded by credit rating agencies. The other three insurers also came under increased credit scrutiny. The bond insurers became such high risks themselves that investors no longer priced the insurance into the value of the bonds. In fact, this caused Vanguard to close its Insured Long-Term Tax-Exempt Fund (VIPLX) and merge it with the Vanguard Long-Term Tax Exempt Fund (VWLTX).
I think all of these factors have worked together to depress the market for municipal bonds and muni funds in general. The question now is when will the value of muni funds come back? That is hard to say. Until it becomes clear that state and local governments are back on sound financial footing, potential baby boomer investors in muni bonds and funds are likely to stay away from them and even continue to sell them, depending on their tax situation and risk tolerance.
On the other hand, two scenarios are on the horizon that could be positive for muni bond investors. Marginal tax brackets for high income taxpayers are likely to be increased, possibly as soon as 2009. If that happens, these taxpayers will be looking for alternative investments that will minimize their tax burdens. Muni bonds and funds are an alternative investment that may appeal to these investors, driving values back up. Second, the now favorable tax rates on dividends and capital gains are likely to be increased, at least for those in high tax brackets. This will also increase the popularity and value of muni bonds and funds.
Update 1: Municipal bond funds still carry significant risk, although some muni bond funds are better than others.
So, that’s Mr. GoTo’s analysis. What about yours?
Image credit: Svilen Mushkatov