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Oct. 26, 2020, 9:53 a.m. EDT

The high yields on municipal bonds are tempting, but you need to be mindful of these hidden risks

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By Philip van Doorn

Municipal bonds have high yields, making them more attractive than U.S. Treasury bonds. But you better be careful.

Municipal bonds are typically exempt from federal income taxes, and if they are issued within your state, exempt from state income taxes too.

What may surprise you is that yields on investment-grade municipal bonds (“munis”) are higher than they are for U.S. Treasury bonds, which are subject to federal income taxes. But you need to use a careful strategy to avoid two important risks.

Philip Palumbo, the founder and CEO of Palumbo Wealth Management in Great Neck, N.Y., says municipal bonds provide a “good balance” for large portfolios that also include stocks. But he also sees elevated default risk for munis because the coronavirus pandemic and economic shutdown have caused a tremendous decline in states’ tax revenue. A $3.1 trillion national budget deficit makes the prospect of a federal bailout of states less likely.

Palumbo recommends avoiding concentration in the municipal bonds of a single state, even if you are living in one with very high income taxes, such as New York or California. During an interview, he said the advantage of avoiding state income taxes on muni bond interest is “minimal when compared to the extra risk you are taking.”

So go with a varied portfolio from many states, be content to avoid federal income taxes and tolerate state income taxes.

As an active money manager, it’s no surprise that Palumbo believes an active approach to managing bond portfolios is best, not only because of the higher credit risk for certain types of munis (which is explained below), but because professional bond managers can take advantage of disruption in pricing, such as what we saw in March and April.

But for this, he turns to firms that specialize in running municipal bond portfolios for investment advisers’ clients. One of these is Clinton Investment Management, which is based in Stamford, Conn., and runs about $1 billion in bond portfolios, working with nearly 80 outside investment advisers.

“The value proposition is very strong” for municipal bond investors who hold their own bonds, rather than shares of a mutual fund, Palumbo said. “Separately managed accounts can often save investors a lot of money relative to actively managed funds.”

First, a few definitions. A bond is issued at its face value, which is called par. The interest rate is called the coupon. In this example, a bond is issued for $10,000 and its coupon is 4%. This means a bond investor who holds it for a year will receive $400 in interest. The sample bond matures in 10 years. Most bonds also have earlier call dates, when the issuer can redeem the bond for at least face value.

After a bond is issued and purchased by an investor, it can be sold on the open market at any time. But its market value will fluctuate. If our $10,000 bond is trading at its face value, we say it is trading “at par.” If it is trading at a premium of 5%, you will pay $10,500 to buy it, and we say it is trading at 105. If it is trading at a discount of 5%, it is worth $9,500 on the open market, and we say it is trading at 95.

If you buy a bond at a premium or a discount to face value, your current yield is not the coupon. It is the annual coupon payment divided by the price you pay for the bond. So if you pay 105 for our $10,000 bond, you paid $10,500 and receive $400 in interest per year, so your current yield is 3.81%. If you still hold the bond when it matures or is called, you will book a $500 net loss.

It may be well worth taking that eventual loss to get an attractive yield. You can look at a bond’s yield to maturity, which factors a net loss (for a bond purchased at a premium) or a capital gain (for a bond purchased at a discount) into an annual yield. But you really want to look at “yield to worst,” which does this calculation based on the earliest date the issuer may redeem the bond.

According to Andrew Clinton, the founder and CEO of Clinton Investment Management, the yields to worst for investment-grade municipal bonds (rated Baa or higher by Moody’s Investors Service or BBB or higher by S&P Global) with an average of10 years until maturity now range between 2% and 2.25%. Those compare quite favorably with the yield on 10-year U.S. Treasury notes /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +3.05% , which is about 0.81%.

Looking at corporate bonds, the Bloomberg Barclays U.S. Aggregate Bond Index has a yield to worst of only 1.22%, according to FactSet.

So even before considering the tax advantages, the muni yields are higher. For comparisons of yields for municipal bonds and taxable bonds, you can calculate a taxable-equivalent yield for the muni by dividing its yield by 1 minus your highest graduated tax rate.

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