Tips for navigating municipal bond funds

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Everyone knows that municipal bonds, or munis, are getting pummeled.

But take heart. Some munis are safer than others if you can handle the bumpy ride. Sticking with high-quality, municipal bond funds run by seasoned managers is the key to navigating munis right now.

These days, chasing yields is out. Quality is in.

“In calm markets, give me the higher yields,” says Matthew Tuttle, chief executive of Tuttle Wealth Management LLC, in Stamford, Conn. “Now, stick with funds with higher-quality bonds.”

Types of municipal bonds

The public debt market is huge — $2.9 trillion.

Typically, muni bonds are issued by local or state agencies to raise money for construction projects, while many are tax exempt.

Topping the capital structure are general obligation bonds, which are backed by tax funds and used for community improvements. “Generally, start with these bonds,” says Rick Ashburn, chief investment officer at Creekside Partners in Lafayette, Calif.

Revenue bonds issued for essential services are among the safest because they are secured by specific income. They are essentially for financing monopolies like city or county water utilities, says Ashburn.

Ashburn says that a roiled muni market “is a good time to buy terrific, cheap assets.”

There are still risks

Not that there aren’t dangers. Experts like Wall Street bank analyst Meredith Whitney have said that there will be dozens of municipal bond defaults. And stories about debt-laden states such as California, Illinois and New York have made investors understandably jittery.

“The outflow of money has been relentless,” says Marilyn Cohen, founder of Envision Capital Management in Los Angeles.

In January alone, more than $12 billion flowed out of these municipal bond funds, according to the Investment Company Institute in Washington, D.C.

Yet even Cohen thinks the future for munis has brightened lately. “New governors and old ones are thinking unconventionally,” she says. “There’s hope that they will deal with their problems.”

And some financial advisers even think the worries over municipal bond debt are overblown.

“It’s such a huge muni market, you can spread out your risks,” Cohen says. “If one or two munis blow out, it won’t reverberate throughout your portfolio.”

Bonds more likely to default include those issued by public nursing homes, hospitals and parking structures, experts say.

Even so, actual municipal bond defaults are rare. From 1999 to 2009, only 10 entities defaulted on payments, according to Fitch Ratings. That’s because debt burdens are low compared to corporate or federal government debt, Ashburn says.

Weathering muni fund investing

Here are some tips for profiting from municipal bond funds in a challenging time.

  • Opt for national, diversified funds. These funds can diversify risks by investing in munis in 50 states. Conversely, single-state or local funds are more vulnerable. “But it depends on what state you’re in,” says Tuttle. “If your state has its fiscal act in order, that’s OK.”
  • Avoid funds that hold munis subject to alternative minimum taxes. Alternative minimum taxes are special taxes that some municipal bonds carry that high-income individuals may have to pay. In fact, municipal bonds subject to alternative minimum taxes aren’t really strictly defined munis. “They’re issued for private purposes,” Tuttle says. They are single-purpose bonds used to finance a project like a convention center or stadium.
  • Scrutinize managers’ track records. Fund managers should have 10 years of fund-management experience or more. And they will need every bit of it, because individual municipal bonds aren’t as transparent as corporate bonds, making them harder to vet even for professionals.
  • Look for solid track records over time. “Managers should consistently be in the top 25 percent of fund performers year after year,” says Tuttle.
  • Identify funds with low expense ratios. Fees make a difference in your return, says Ray Lucia, a Certified Financial Planner in San Diego. “We’re talking about low yields,” he says.
  • Go for shorter-term maturities. To protect yourself from the risk of rising interest rates, which push bond prices down, opt for municipal bond funds that hold bonds with five- to seven-year time frames. “We don’t think the extra yield for longer maturities is worth the risk,” Ashburn says.