Packing A Punch

When you want an investment that has some punch in today's uncertain market, a municipal fund may be a good contender.
Magazine Contributor
7 min read

This story appears in the April 1998 issue of Entrepreneur. Subscribe »

Every so often, stocks do something unexpected: They go down instead of up. For neophyte investors, memories of the last bear market (in 1994) may not be part of their memory banks. More experienced investors may recall 1990 as a dismal way to begin the last decade of the century. Few investors and perhaps almost as few can recall the battering that stocks took in the ugly 1970s market. But no matter what your frame of reference is, to have a fighting chance of reaching your financial goals, you should put your money into more than one investment class.

Smart investors know diversification is the one-two punch that can help secure long-term financial success. These days, everyone is an investment expert, from the CNBC gurus to your barber who dabbles in the market. Their advice runs the gamut from highly sophisticated management and models to a basic diversified portfolio. Some strategies are easy to understand, while others defy all logic. Municipal bonds, for example, may have a place in investors' portfolios, but often, these special securities aren't recognized for the jewels they are. The question is, Why municipal bonds now?

Lorayne Fiorillo is a financial advisor at Prudential Securities. All figures are courtesy of Prudential and are as of February 6, 1998. Past performance is no guarantee of future returns. For more information, write to Lorayne in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.

Put Up Your Dukes

At first glance, "munis" may not seem so attractive. Interest rates are low on taxable investments. In fact, you can get the same rate of return from short-term investments that you can get on a tax-free bond, and markets don't make you tie up your money. So what's the fascination with municipal bonds?

First and definitely foremost, that "low interest rate" you may have seen advertised can be deceptive. Interest from municipal bonds is generally free from state and federal taxes, provided you buy bonds issued by your state of residence. Exceptions include Illinois, Iowa and Kansas, where state taxes are charged on interest, and Florida, Nevada and Texas, which levy no state or local income taxes. While interest is tax-free, capital gains on the sale of the bonds are subject to tax. Income for some investors may also be subject to the federal Alternative Minimum Tax, so consult your tax and financial advisors before you invest.

Many investors are turned off by municipal bonds because of their paltry yields. After all, why invest in a AAA-rated 30-year municipal bond paying only 5.25 percent when you can purchase a Treasury bond of the same maturity yielding 6.13 percent? You don't have to be a rocket scientist to figure that one out . . . or do you? Financial advisors are fond of saying it's not what you make on an investment, it's what you keep. Let's compare the two aforementioned investments after federal taxes, considering a 30-year AAA-rated insured municipal bond yielding 5.25 percent vs. a 30-year Treasury bond yielding 6.13 percent.

Taxable equivalent yields:

  • An investor in the 39.6 percent federal tax bracket: 8.69 percent
  • The 36 percent tax bracket: 8.2 percent
  • The 31 percent tax bracket: 7.61 percent
  • The 28 percent tax bracket: 7.29 percent

The winner and heavyweight champion? You guessed it: For high-income investors, municipal bonds generally provide better after-tax returns. The secret is to look beyond the initial coupon at the after-tax yield before you shy away from municipal bonds.

You Can Still Be A Contender

Today's tax-exempt municipal market and America's changing demographics give investors a chance to get in on the municipal bond market. Remember the old supply-and-demand rule? When demand exceeds supply, prices begin to rise until consumers are no longer willing to pay the asking price. This principle applies whether you're talking about groceries, cars, or stocks and bonds. Let's look at both sides of the equation.

On the demand side, consider the baby boomers, which account for nearly one-third of all Americans. Whenever the boomers arrive on the scene, they increase demand. First it was the diaper industry, then they flooded the school system. As the boomers head toward retirement, they'll continue to dominate the scene.

The first of the boomers will reach age 65 in 2011. As investors age, many increase the percentage of their portfolios in fixed-income investments; boomers will probably be no exception. While many kinds of fixed-income investments are available, only municipal bonds offer the exemption from taxes that these retiring investors could use to maximize their after-tax returns. Unlike previous generations, the boomers are expected to have accumulated more wealth than any preceding generation and may invest in municipal bonds in droves, sharply increasing demand.

On the supply side of the equation, consider the municipal market itself. The available supply of tax-exempt municipal bonds has been shrinking in recent years. In the three-year period ending in 1996, new municipal financings totaled approximately $603.4 billion, while bond redemptions totaled $875.5 billion. This means that $248.2 billion worth of municipal bonds disappeared from the marketplace during this three-year period. Taxpayers have also become reluctant to pass bond referendums, so no one is expecting a rash of new financings in the near future. Market analysts predict that new issuance will remain relatively constant, in the $190 billion to $200 billion per-year range, over the next several years.

What does this mean to investors? The potentially growing demand and shrinking supply should result in municipal bonds trading at higher relative prices than we're currently experiencing. Over the past 15 years, yields on municipals (measured by the 20-year Bond Buyer Index) have ranged from 77 percent to 86 percent of the 30-year Treasury bond. If demand from baby boomers sparks the municipal market, the relationship between munis and Treasuries could move into the 70 percent range. Today's municipal buyers could have a tax-free, interest-paying, highly demanded investment on their hands. And at these projected levels, munis would still be attractive to anyone in the 28 percent or higher federal tax bracket. One catch: They won't be as attractive as they are today at an 83 percent-plus relationship.

It's All In The Footwork

Where should investors look for the best values in today's municipal market? Bubba Bennett, senior vice president and director of national fixed income marketing at Prudential Securities, suggests investors consider bonds that will mature in the next six to 15 years. "The best part of the yield curve is the six- to 15-year range. Beyond 15 years, the curve is flat," says Bennett, and investors won't make much more for an increased . He gives this example: If a 30-year AAA-rated municipal bond yields about 5.1 percent, a 10-year bond with the same rating yields about 4.35 percent. Investors in the 10-year maturity would get 85 percent of the yield of the 30-year bond, but they would experience much less volatility. Because yields and market values fluctuate, an investment sold before maturity may be worth more or less than its original cost.

Another area Bennett suggests investors check out is the insured municipal market. Here, issuers with poor credit quality buy insurance that guarantees the timely return of investors' principle and interest. Bonds will carry a AAA rating by Moody's and Standard & Poor's. When yields on 10-year AAA-rated insured bonds are about 4.45 percent, yields on A-rated munis of the same maturity are usually about 4.6 percent. Although this relationship is subject to change, and there's nothing wrong with an A-rated bond, why take the additional risk for only 15 basis points?

If stocks do experience a bear market or, at the very least, a temporary pullback in the near future, municipal bonds can provide a safe haven to protect your profits. A mixture of stocks and bonds has generally proved to be more efficient in the long run than a of only stocks or bonds. Stocks can provide growth at the expense of volatility, while bonds offer income along with relative credit safety and return of principal. Together, they can provide a knockout team of investments.

Contact Source

Prudential Securities, (212) 778-3750, fax: (212) 778-1072.


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