MONEY

Munis on the Rise

Learn how to profit from the rebound in public sector debt. Photo: Yasu + Junko

You’d think that with bankrupt Detroit fighting to slash payments to its bondholders, Chicago’s debt being downgraded because of pension problems, and Puerto Rico’s credit rating being reduced to “junk” status, these would be hard times for municipal bonds. Well, you’d be wrong.

Munis lost as much as 6% in the middle of 2013, owing to those troubled locations and the effects of rising interest rates. Now they’re making a bid for comeback investment of the year.

Debt issued by states and municipalities has beaten the broad fixed-income market so far this year, continuing a trend that started last September. Since then munis, whose income is exempt from federal (and in many cases state) income taxes, have returned 5.5%, vs. 3.2% for taxable bonds.

Why the turnaround? Part of it has to do with value.

In January, MONEY noted that fiscal worries in high-profile cases were creating real bargains. Now, the health of the broader market is also looking up for these reasons:

Today’s headlines are masking a broader truth. Crises in Detroit and elsewhere belie the fact that the U.S. economy is gradually healing to the point where state and local coffers are on the mend. Last year, for instance, less than 0.11% of high-grade munis defaulted, down from 0.23% in 2011.

Much of the market’s pain has already been felt. Credit problems in Detroit and Puerto Rico contributed to muni fund losses last year, as did rising interest rates, which lower bond prices.

Long-term rates are likely to drift higher this year if the Federal Reserve continues to taper its stimulus efforts, but market watchers say most of the damage was done in 2013 when yields on 10-year Treasuries nearly doubled from 1.6% to 3%.

Related: Americans Still Worried About Their Financial Future

“Unless there is some external shock, we don’t expect rates to go significantly higher from here,” says Peter Hayes, head of BlackRock’s municipal bond department.

The policy backdrop has changed. Talk of limiting tax breaks on munis, which sprang up a few years ago, has died down. At the same time, the new 39.6% top income tax rate is here for couples earning more than $450,000 a year (the old top rate used to be 35%).

There’s also a new 3.8% surtax on certain investment income, from which muni income is exempt. That surtax is levied on top of capital gains taxes for couples with modified adjusted gross income of $250,000 and singles at $200,000.

“The tax-free interest of municipal bonds should get more attention in light of those new tax rates,” says James D’Arcy, manager of Vanguard Intermediate-Term Tax-Exempt VANGUARD MUNICIPAL INTERMEDIATE TERM PORTFOLIO VWITX -0.2088% , which is in the MONEY 50, our recommended list of mutual and exchange-traded funds.

Munis offer an income advantage. If you hold bond investments in taxable accounts, munis deserve a serious look — and not just if you’re in the top bracket. Consider that the Vanguard Total Bond Market Fund, which owns a diverse mix of high-quality U.S. corporate and government issues, sports an after-tax yield of 1.5% for those in the 28% income tax bracket. By contrast, Vanguard Intermediate-Term Tax-Exempt pays you 2.1%.

Of course, risks remain. Rates could climb higher than expected. And with bond insurance coverage down significantly on new issues ever since the financial crisis, the municipal market is going to be more volatile than you might assume, says Lyle Fitterer, co-manager of the Wells Fargo Advantage Intermediate Tax/AMT-Free WELLS FARGO FUNDS ADVANTAGE INTER TAX/AMT INV SIMBX -0.1705% .

So you’ll want a smart strategy like the one below:

Find the sweet spot in high grade

In a potentially rocky market, don’t go with high-yield junk bond funds, which sank more than 10% amid the worst of last summer’s muni storm. Stick with high-quality municipal debt instead. Within that universe, BlackRock’s Hayes recommends looking for portfolios with big stakes in single-A-rated munis (investment-grade issues are rated AAA, AA, A, or BBB).

Over the past decade, Hayes says, A-rated bonds have outperformed the broad market in up years while performing no worse than average in down years.

Vanguard Intermediate-Term Tax-Exempt keeps about a third of its assets in As, while Wells Fargo Advantage Intermediate Tax has more than 40% — well above the 23% category average.

Take a long look at intermediate-term bonds

Investors have been rushing into bonds maturing in five years or less lately because these securities aren’t as vulnerable to rising interest rates as are long-term bonds. The result: “Bonds with three- to five-year maturities are the richest part of the market right now,” says Robert Miller, co-manager of the Wells Fargo fund.

On the flip side, payouts for 10-year A-rated bonds have risen from 1.6% last year to 2.1% today.

Related: Fresh Thinking on Income Investing in a Low-Yield World

Going whole hog into long-term issues, though, sets you up for some stomach churning when rates rise. The solution: Seek out funds with around a five-year average “duration” but that also have a decent slug of long-term exposure. (Duration is a measure of rate sensitivity. If market rates were to rise 1 percentage point, a fund with a five-year average duration would lose around 5% in price, while a 10-year duration fund might drop twice as much.)

A good example is Fidelity Intermediate Municipal Income FIDELITY SCHOOL ST INTERMEDIATE MUN INCOME FD FLTMX -0.1885% . The fund sports an average duration of 5.6 years, yet around half the portfolio matures in a decade or more.

Build a ladder — but one’s that long enough

In a rising rate environment, laddering your debt — in other words, holding various bonds that mature in routine intervals — makes sense.

There are new types of exchange-traded funds managed by iShares that invest in munis that all mature in the same year, making it possible to ladder funds. Unfortunately, the longest-dated version of these muni ETFs matures in just five years. To capture the market’s extra yield, you’d want to make sure the oldest bonds in your ladder come due at least a dozen or more years from now.

If you go with individual securities, strategists recommend sticking with high-quality revenue bonds. Their payments are backed by income from an essential service, such as water and sewer projects or electric power plants.

Related: The Easiest Way To Juice Your Portfolio? Minimize Taxes

And make sure you have at least 10 rungs in your ladder, says Rob Williams, director of income planning for the Schwab Center for Financial Research. That means buying 10 munis, the first that matures a year and a half from now; the next, three years from now, the one after that, 4½ years from now, and so on, until you get to 15 years.

By doing so, you’ll enjoy higher yields that longer-date bonds offer without going overboard. And as interest rates rise, you can reinvest maturing bonds into new 15-year securities paying ever-higher yields.

In the new muni landscape, where opportunities are presenting themselves even as risks remain, that’s how to get a leg up.

MONEY IRAs

The Easiest Way to Juice Your Portfolio

Take best advantage of the tax code to increase your portfolio's real rate of return. Photo: Drazen/Shutterstock

There's one absolutely foolproof way to become a better investor: Don't leave free money on the table. Designing your portfolio so that it takes best advantage of the tax code is a risk-free way to boost your true, after-tax return.

The basics: Use tax-advantaged accounts first

Before you make any other investments, max out your 401(k) and Individual Retirement Account options first. Deductible traditional IRAs and 401(k)s allow you to invest pre-tax dollars now and have the money accumulate tax-free until you make withdrawals in retirement. The withdrawals are then taxed as ordinary income.

With a Roth IRA, you pay the taxes up front — that is, unlike with a traditional IRA, your contributions aren’t deductible. But withdrawals in retirement are tax free.

There are limits to how much you can contribute to either kind of IRA, and some high earners might not be able to contribute to a deductible IRA or directly to a Roth. There is, however, a “back door” into a Roth for those above the income limits. You can contribute to a non-deductible IRA and then immediately convert to a Roth. (Caution: If you hold other money in traditional IRAs, there are potential tax consequences to this move. So read “The other way to invest in a Roth IRA” before making this move.)

Roth or traditional IRA?

In general, a traditional IRA makes sense if you think you will face a lower tax rate in retirement than you do today. But of course you can’t be 100% certain what tax rates will be when you retire, so some advisers say it makes sense to hedge your bets by holding some money in both kinds of tax-advantaged accounts.

Investments that hold down the tax bill

Once you’ve exhausted your tax-advantaged options, look for investments that minimize what you’ll owe. If you are investing in stocks, an index fund is usually a good option. Because these funds tend to hang onto the stocks they buy, they are less likely than most actively managed funds to incur lots of taxable capital gains that must be distributed to shareholders.

Income-seeking investors can consider tax-exempt municipal bonds, either directly or via a fund. These bonds are generally issued by state or local governments, and the income they pay is free from federal taxes. They may also be free from state income taxes, depending on where you live and where the bond was issued.

Road to Wealth: The college savings cheat sheet

Because the tax break is valuable, these bonds don’t have to offer yields as high as comparable fixed-income investments. That means they make the most sense for high-income investors who face relatively high income-tax rates.

Currently, however, a number of factors have combined to make municipals look attractive to a broader range of investors. In particular, the rates on other types of bonds remain low, and municipal bonds appear to have been unfairly stigmatized by a few high-profile recent crises like those in Detroit and Puerto Rico; as a result, tax-exempt munis are worth a look even if you’re not in a high tax bracket.

Location, location, location

Investors with significant assets spread across both tax-advantaged and taxable accounts should think carefully about which investments go where. Investments that pay out ordinary income, such as bond funds, may be best suited to tax-advantaged accounts, since that income faces higher rates than long-term capital gains or qualified stock dividends.

MONEY bonds

Bonds: Where to Find Higher Yields

Municipalities frequently sell bonds to finance transportation construction projects. Photo: Shutterstock

What’s happening in bonds? A second year of rates grinding higher signals a key turning point.

“The days of earning 7% total returns as yields fall are over,” says Bob Persons, co-manager of the MFS Bond Fund. “We’re now looking at an environment where you should expect 2% to 4%.”

That’s not a call to bail out of bonds. “Remember, the reason you own bonds is to control the overall risk of your portfolio,” advises Wayne Schmidt, chief investment officer at Gradient Investments.

Treasuries, the ultimate safe haven, are also the most sensitive to rising rates. Long-term ones took a serious hit during the four-month rate spike in 2013. And a total bond index mutual fund or an exchange-traded fund, which tends to act like an intermediate-term fund, is bulked up on Treasuries today.

The Barclays U.S. Aggregate index SPDR SERIES TRUST BARCLAYS AGGREGATE BD ETF LAG -0.0496% , the benchmark for most diversified bond funds, has more than one-third in Treasuries, compared with 20% a decade ago.

So to temper your rate risk and earn more than the 2% your core bond fund is paying, peel off a small portion — say 20% or so — and redirect it to other pockets of the bond world, starting with the ideas below.

1. Aim for the sweet spot with corporates

With yields on five- to 10-year corporate bonds up far more than short-term rates, you’re being rewarded more than you were a year ago for tiptoeing into longer maturities. And as long as you’re patient, you can withstand rate hikes.

Stick to corporate funds with durations of five years or so (duration indicates what percentage a fund’s price will fall per a one-point hike in rates). And to wring out more income without undue risk, sacrifice a little on quality with BBB-rated bonds, the lowest rung of investment grade. “Companies are reporting record free cash flows, and the economy is growing,” says Persons. “There’s no need to be so defensive.”

How to invest: The USAA Intermediate Term Bond Fund USAA MUTUAL FUNDS INTERMEDIATE-TERM BOND FD USIBX 0.0912% (3.6% yield) has 48% of the fund in BBB and single-A issues, 25% higher than the category norm.

2. Municipal bonds are today’s best value

Muni bonds typically pay less than comparable Treasuries. Yet today high quality munis yield at least as much, even before the tax break. The reasons: investor jitters in the wake of Detroit’s bankruptcy and concerns over Puerto Rico’s financial stability. (Many muni funds own Puerto Rican debt because interest is tax-free in all 50 states; the typical muni fund, though, has less than 5% of assets in Puerto Rico bonds, reports Morningstar.)

Still, fewer than 1% of all muni bonds are in bankruptcy. “The vast majority of the market is fundamentally sound,” says Mark Paris, a municipal bond manager at Invesco, “and with the economy improving, municipalities are seeing their revenue improve as well.”

These days Marilyn Cohen, whose Envision Capital Management specializes in fixed-income investing, favors revenue bonds, whose payments rely on a steady stream of income from essential public services like water and electricity. General obligation bonds, on the other hand, are backed by a municipality’s ability to raise taxes, which is often politically unpopular.

How to invest: Vanguard Intermediate Term Tax-Exempt VANGUARD MUNICIPAL INTERMEDIATE TERM PORTFOLIO VWITX -0.2088% , a MONEY 50 fund (recent yield 3.2%), has just 28% in G.O. bonds and an average duration of 5.5 years. The iShares National AMT Free Muni ETF ISHARES TRUST NATL AMT FREE MUNI BD ETF MUB -0.178% (2.9%) keeps more than two-thirds of the portfolio in revenue bonds; its average duration is seven years.

3. With high yield, look for quality

If you’ve been enjoying high payouts from junk bonds of late, you’ve no doubt noticed that yields have fallen from above 8% two years ago to under 6% today; income seekers have been flocking into the market, pushing prices higher and yields lower. Plus, a record amount of ultra-low-rated corporate bonds were issued last year, amping up the risk in this already dicey sector.

Since you’re not getting paid nearly as much as you once were to take on the stocklike price swings of junk, Wells Fargo’s Jacobsen recommends tilting toward the highest-rated portion of high yield: “crème de la junk” rated BB, where you can still get a 4.5% to 5% yield without taking on the risks of the lowest-quality issues. In the 2008-09 selloff, bonds rated BB lost 16%, while CCC and lower-rated bonds lost 41%.

How to invest: The Power Shares Fundamental High Yield Corporate Bond ETF POWERSHARES GBL EX FUNDMTL HIGH YIELD BD PORT PHB 0.2611% (4.6% yield) focuses on quality junk; currently more than two-thirds of the bonds in the portfolio are rated BB or higher, and the fund owns no bonds rated below B.

4. Embrace a new way to avoid price swings

You can boost your income by shifting money into corporates, munis, or high-yield bond funds, but you are putting your principal at risk — you could take a loss if you have to sell when rates are on the rise and prices are down. With individual bonds, on the other hand, if you hold on until maturity, you know exactly how much you’ll get back. The downside is that it’s costly to put together a diverse portfolio.

A new breed of ETFs gives you the “best of both worlds,” says Gradient Investments’ Schmidt. With defined-maturity ETFs from Guggenheim and iShares — portfolios of corporate and municipal bonds that all mature in the same year—you get diversification and the knowledge of how much you’ll get back and when.

How to invest: Both firms offer maturities ranging from one to seven years, so you can lock in short and intermediate rates. “lt’s a cost-effective way to own a portfolio of bonds but also control your interest rate risk,” says Schmidt.

How to build a ladder

With $10,000, you can create a high-quality corporate bond ladder with Guggenheim Bulletshares defined-maturity ETFs.

Yield on each $2,000 investment by maturity date:

2015: 1.5%
2016: 1.7%
2017: 1.93%
2018: 2.30%
2019: 2.85%
Effective yield: 2.1%
SOURCES: Morningstar, MONEY research

MONEY Investing

How Detroit’s Breakdown Will Hit You

Detroit’s July bankruptcy is the tragic culmination of 60 years of decline.

Indeed, among localities still coping with fallout from the recession and housing bust, the Motor City stands alone in awfulness: 78,000 blighted structures, 18% unemployment, a $327 million operating deficit last year. Yet with the city looking to cut pensions and restructure debt, Detroit’s comeback bid could have ramifications beyond Michigan’s borders.

Your town may feel freer to slice retiree benefits. With so many state and local pensions facing funding shortfalls, cutting back retirement benefits — or trying to — is nothing new. What worker advocates fear is that bankruptcy-court approval of pension changes for Detroit, where pension protection is part of the state constitution, would embolden government leaders elsewhere to seek deeper cuts.

Related: Just how generous are Detroit’s pensions?

In Detroit, pension changes are most likely to follow the national trend: eliminate cost-of-living adjustments and convert current workers to defined-contribution plans, says area financial planner Leon LaBrecque, rather than reduce payments.

The muni market could take a hit. Detroit has proposed treating certain general obligation bonds as “unsecured,” instead of backed by city taxing power, and offering investors just 10 cents on the dollar.

The odds are long, but if Detroit succeeds, the precedent would shake up the bond market.

Also at risk: retiree health care, which lacks the same protections as pensions. Detroit would shift retirees to new federal exchanges or Medicare, a move other governments are studying.

Related: Detroit’s stealth business boom

Still, for most of the country, “credit quality remains quite strong,” says John Bonnell, a fixed-income manager for USAA. The five-year default rate in the $3.7 trillion muni bond market is less than one-half of 1%, reports Moody’s; 93% of municipal issuers are rated single A or higher.

Michigan muni funds already have. Funds that specialize in the state’s bonds are down as much as 17% this year, but at this point you shouldn’t rush to sell, says Chris Ryon of Thornburg Funds. Even funds with big stakes in Detroit primarily hold the water and sewer bonds that Detroit is still fully backing, not the unsecured debt the city is defaulting on.

But the real story on bonds is … Munis are less liquid than the Treasury market, and thus have taken a bigger hit as interest rates have risen of late. But David Kotok, chairman of money manager Cumberland Advisors, thinks the fear has been overplayed.

“High-grade munis are remarkable bargains,” says Kotok. Still, stick with a short-term fund, such as Fidelity Short-Intermediate Muni Income FIDELITY MUNICIPAL LTD TERM MUN INCOME FD FSTFX -0.0929% (recent yield: 1.77%), to cushion any losses as rates rise.

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