MONEY municipal bonds

Muni Bonds are Beating Stocks This Year. What to Know Before You Jump In.

Municipal bonds are on a tear. On Monday The Wall Street Journal noted that the normally staid $3.7 trillion sector has returned 8.3% so far this year, outperforming the Dow Jones Industrial Average and highly rated corporate bonds. Readers of MONEY’s print edition shouldn’t be surprised. Our April issue argued these bonds could “make a bid for comeback investment of the year.” If munis are just getting your attention now, here are four things you need to know:

Munis benefit some investors more than others

Munis’ interest payments are exempt from federal and sometimes state and local income tax. That means, all other things being equal, those who pay higher tax rates enjoy a bigger benefit. Just how good a deal is it? Because municipal bond buyers are well aware of the tax perks, muni bonds typically yield less than Treasuriess. So to find out if munis make sense for you, you need to look at the difference between these two yields and compare with your tax rate.

The question can also be complicated factors like where you live and whether you are subject to the alternative minimum tax or the new Medicare tax on investment income.

But there is a basic rule of thumb. Start by subtracting your tax bracket from 1. So if you are in the 33% bracket you are left with 0.67. Then divide the municipal bond’s tax-free yield by the resulting number. Finally compare the result to the yield on a taxable investment. Right now the 10-year Treasury yields about 2.3%. Top-rated muni bonds with similar 10-year durations are yielding 2.1%. The upshot: A muni investor in the 33% tax bracket could grab an after-tax yield of 3.1%. For an investor in the 25% bracket, the after tax yield falls to 2.8%.

Munis aren’t risk free

Although munis may offer an after-tax yield advantage, it comes at a cost. While Treasuries issued by the Federal government are considered iron-clad, municipal bonds’ credit risk can range from triple-A to junk, not unlike bonds issued by companies. While you can certainly buy bonds backed by, say, the State of New York or California, many municipal bonds are issued by less august entities — a particular city or school district. Still others may be backed by a particular stream of revenues — like the tolls collected on a particular road. In all there are more than 15,000 issuers, according to Moody’s. Even counting small issuers, municipal defaults are rare. But political impasses — like the 2008 California budget deadlock — can give the markets jitters, driving down prices. Sometimes, as the news out of Detroit or Puerto Rico show, the problems really are serious.

Where you live has a lot to do with the fund you should buy.

Municipal bonds may carry state and local tax perks. For instance, income from municipal bonds issued by a particular state is typically exempt from state income taxes for residents of that state. In other words, New Yorkers who own New York bonds get a state tax break on top of their federal income tax benefits. That’s why there’s a proliferation of municipal bond mutual funds targeting individual states, especially populous and high-tax ones like New York, California, and New Jersey.

There are some wrinkles that may surprise you, though: Bonds issued by territories like Puerto Rico are exempt from state taxes everywhere. That’s helped make them far more popular than they might otherwise be. (They may even turn up in funds labelled “New York.”) So Puerto Rico’s fiscal problems have had a real impact on individual investors on the U.S. mainland.

If you’re just buying now, the deals are less attractive

Of course, while the tax benefits of municipal bonds can seem attractive, taxes should never be your only consideration for an investment. You also have to judge whether the price you’re getting will turn out to be a bargain, and the yields the bonds are offering now are looking a bit thin. (Remember, as bond prices rise, yields fall.) Muni bonds had a rough 2013, declining about 2.6% at a time when Detroit’s fiscal problems were continually making headlines. But munis haven’t just snapped back. They’ve put together their longest string of monthly gains in two decades, according to the Journal. Such a sharp rally can only mean that investors’ return prospects have gotten a lot less rosy.

“It’s difficult to find real value in the muni market these days, but if you already own munis, you should stick with what you own because it’s hard to replace that income,” Jim Kochan, a senior investment strategist at Wells Fargo Advantage Funds recently told investment bible Barron’s. “Whenever we’ve been at these yields in the past, it’s never been a good time to buy, because the market usually corrects.”

MONEY bonds

Risky Puerto Rico Funds Are Still on UBS’s Menu

UBS
Matthew Lloyd—Bloomberg via Getty Images

Brokers, according to an October memo, can recommend clients buy bond funds at the center of a recent $5.2 million settlement and hundreds of arbitration claims.

UBS is sticking with its recommendations that some clients buy risky Puerto Rico closed-end bond funds, despite hundreds of arbitration claims by investors who blame the securities for huge losses, according to an internal document.

UBS told brokers that they may continue to recommend the funds to clients following a $5.2 million settlement last week with Puerto Rico’s financial institutions regulator about sales practices involving the funds, according to an Oct. 9 internal memo reviewed by Reuters.

However, brokers “should continue to evaluate investment recommendations in a manner consistent with UBS policies and FINRA rules,” the firm said in the four-page memo, written in a question and answer format. FINRA, the Financial Industry Regulatory Authority, is Wall Street’s industry-funded watchdog.

Brokers who have questions about whether a “particular investment recommendation” is suitable should contact their branch manager or the firm’s compliance department, UBS wrote.

It is unclear who wrote the memo, which is unsigned.

A UBS spokeswoman did not say whether the firm planned to give more specific guidance to brokers. She said brokers consider “each client’s entire range of wealth management needs and goals when devising their financial plans.”

She noted that Puerto Rico municipal bonds and closed end funds provided excellent returns for more than a decade, as well as tax benefits.

FINRA requires that investment recommendations be “suitable” for investors, based on factors such as risk tolerance and age.

Lawsuits have been mounting, and there are more than 500 arbitration claims against UBS following a sharp decline in the value of Puerto Rico municipal bonds last year. Investors in closed-end funds with heavy exposure to those bonds suffered deep losses.

Puerto Rico regulators interviewed a sampling of UBS clients while looking into the firm’s bond fund sales practices. Those interviewed were elderly with low net worth and conservative investment goals, according to the settlement with UBS, also on Oct. 9. UBS did not admit to any wrongdoing as part of the deal.

According to the settlement, six UBS brokers in Puerto Rico “may have” directed their clients to improperly borrow money in order to buy the funds. Lawyers handling the arbitration cases said the investors’ losses were magnified because they invested through the illegal loans, sold through UBS Bank USA of Utah.

Even without the added leverage, analysts say funds that invest heavily in Puerto Rico debt still carry significant risk. Ratings agencies have cut Puerto Rico’s debt to junk status because of significant default risks.

Puerto Rico has an onerous debt burden that faces headwinds of a weak economy and significant unfunded pension obligations, said Morningstar analyst Beth Foos. She declined to comment specifically on the UBS funds.

Analysts said investors continue to buy Puerto Rico bonds, drawn to tax advantages and attractive yields as high as 7.75 percent, even though there is a significant risk that the U.S. territory will not be able to repay its bond obligations.

TIME animals

Behind the Picture: Hansel Mieth’s Wet, Unhappy Monkey

Photographer Hansel Mieth's own attitude toward her famous 1938 portrait of a soaking wet rhesus monkey was, to put it bluntly, conflicted

It is, without question, one of the most famous, most frequently reproduced animal photographs ever made. But photographer Hansel Mieth’s own attitude toward her 1938 portrait of a sodden rhesus monkey hunched in the water off of Puerto Rico was, to put it bluntly, conflicted. In fact, the German-born Mieth (1909–1998) memorably called the creature in the picture “the monkey on my back.”

As Mieth explained in a 1993 interview with John Loengard, published in his book, LIFE Photographers: What They Saw, she made the photograph while covering a Harvard Medical School primate study on tiny Cayo Santiago, off the east coast of Puerto Rico:

One afternoon all the doctors were away [Mieth told Loengard], and a little kid came running to me and said, “A monkey’s in the water.”

I came down, and that monkey was really going hell-bent for something. . . . I threw my Rolleiflex on my back and swam out. Finally, I was facing the monkey. I don’t think he liked me, but he sat on that coral reef, and I took about a dozen shots.

When she got back to New York, Mieth learned that the joke around the LIFE offices was that she’d produced a striking portrait of Henry Luce, the founder and publisher of TIME, LIFE, Fortune and other magazines: evidently, some of her colleagues felt that the rhesus in the water looked like their boss. When asked by Loengard, six decades later, if she felt the portrait did resemble Luce, Mieth was diplomatic.

I didn’t see Luce that much. He had lots of other things to do rather than talk with photographers. . . . But I suppose it does, in a way. It all depends on what kind of mood you are in. To me it looks like the monkey’s depicting the state of the world at the time. It was dark and somber and angry. There were a lot of dark clouds swirling around. I heard from many people that they were scared when they looked at it.

Today, the monkey on Mieth’s back still commands our gaze, inviting us—perhaps challenging us—to project our own fears, anxieties and speculations on to a picture, and a primate, that never gets old.

FINAL NOTE: While a half-dozen lesser pictures from the assignment in Puerto Rico were published in the Jan. 2, 1939, issue of LIFE, Mieth’s now-iconic monkey photo appeared a few weeks later, in the Jan. 16 issue—accompanied by the caption, “A misogynist seeks solitude in the Caribbean off Puerto Rico.”

According to the magazine, a primatologist explained that “the chatter of innumerable female monkeys had impelled this neurotic bachelor to seek escape from the din” by fleeing the jungle and making his way into the waves.

Seventy-five years later, that particular theory about how and why the rhesus was out there in the water still sounds as reasonable as any other.

Ben Cosgrove is the Editor of LIFE.com

TIME Puerto Rico

The Next Financial Catastrophe You Haven’t Heard About Yet: Puerto Rico

On Tuesday, the island sold $3.5 billion in new debt. But the crisis still poses a danger to everyday U.S. investors

Until recently, Puerto Rico was an investors’ tax heaven, renowned for its sandy beaches and killer rum. But the island is in dire financial condition and thousands of U.S. mom-and-pop investors may lose a big part of their savings if the small territory goes bankrupt.

It all started with an over-borrowing spree that lasted for decades. It ended with an island of fewer than four million residents accumulating $70 billion dollars in debt. That is a debt per capita of around $10,600 – or 10 times the median for U.S. states, according to the ratings agency Standard and Poor’s.

Puerto Rico’s over-borrowing was facilitated by an eager group of U.S. investors. U.S. mutual funds were more than willing to buy Puerto Rico bonds, because the island has a special financial advantage: its bonds are triple tax-exempt, which means that bondholders do not pay federal, state and local taxes for their coupon income (i.e. interest) from the bonds.

This created a large buyers base for Puerto Rico’s bonds, which encouraged the commonwealth to keep issuing debt. As a result, today around 70 percent of U.S. mutual funds own Puerto Rico securities, according to Morningstar, an investment research firm that specializes in data on mutual funds and similar investment offerings.

But Puerto Rico did not handle prudently enough this easy cash flow that was coming in. “For years, Puerto Rico practiced deficit financing, which essentially means taking out long-term debt to cover short-term financial needs; this was created by too much spending relative to revenues,” says municipal bond market expert Chris Mier, chief strategist at Loop Capital, an investment bank and advisory firm.

“This is unsustainable from an economic policy point of view in the long run, but since the ratings remained above investment grade, the buyers of the debt did not worry excessively,” says Mier.

The spark that lit the fuse came in 1996, when President Clinton repealed legislation that gave tax incentives for U.S. companies to locate facilities in Puerto Rico. The island’s economy began to sputter, and after the great recession, the decline in the island’s governmental finances continued.

At at time when the island is experiencing steady population loss and very low productivity, the unsustainability of unbalanced budgets and rapidly growing debt became increasingly evident.

Then the downgrades came: in the past several years, ratings agencies gradually downgraded Puerto Rico’s debt notch by notch. And the island’s government continued to promise investors that it would pass a balanced budget – something that has not occurred in over a decade.

To make things worse, a “brain drain” is occurring, as young qualified professionals are fleeing an unemployment rate of 15.4%, compared to the 6.6% federal unemployment rate, according to the U.S. Bureau of Labor Statistics. The fact that Puerto Ricans are U.S. citizens makes migration much easier and appealing, says Puerto Rican consultant Heidie Calero, president of Calero Consulting Group.

Currently, Puerto Rico’s population is 3.7 million on the island, versus 4.9 million Puerto Ricans living on the U.S. mainland. The U.S. Census Bureau projects that the island’s population will drop to 2.3 million in 2050.

“Around 51 percent of the island’s population is on welfare. How do you make them participate in the economy?” asks Calero. The size of the island’s “underground economy” was recently estimated at approximately $20 billion; and that is just an approximation since nobody really knows how much revenue goes unaccounted for, says Calero.

In February 2014, all three major ratings agencies downgraded Puerto Rico’s debt to below investment grade, widely referred to as ”junk” status in bond market circles. This indicates a greater risk of possible default or a debt restructuring. For U.S. investors, this means that the crisis in Puerto Rico will have a severe impact, not only on Wall Street but also on thousands of mom-and-pop investors.

The decline in market value of Puerto Rico bonds has reduced the value of investors’ holdings by at times as much as 35%, says Mier. But Mier cautions that there are many possible scenarios, including favorable ones where Puerto Rico succeeds in resolving its budget and debt problems and returns to investment grade ratings.

But to do that, the government needs to balance two seemingly conflicting goals: economic growth and fiscal austerity, says economist Carlos Soto-Santoni, president of Nexos Económicos, a Puerto Rico-based consulting firm, and deputy advisor for former Governor Rafael Hernández Colón’s administration.

In 2013 alone, the government passed $ 1.36 billion in new taxes. While this increases the government’s revenue, it makes doing business on the island more onerous – which in turn further impedes economic growth, says Soto-Santoni.

Solving the economic puzzle will determine whether Puerto Rico will be for the U.S. what Greece was for the European Union.

Ellie Ismailidou is a reporter for Debtwire Municipals

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