Review & Outlook

Our take on the investing, financial, & economic themes of the day

Trouble in Paradise for Municipal Bonds

18 December, 2013 by Matthew O'Brien, Ph.D. in Commentary

It takes about $25,000 to buy corporate or municipal bonds in a lot that is able to secure a reasonable commission.  Bonds purchased in smaller amounts incur excessive brokerage fees.  For investors who don’t have enough money to purchase individual bonds efficiently, bond mutual funds (and increasingly bond ETFs) can provide a good way to balance out the stock portion of a portfolio.  But investors who can afford to buy individual bonds should, because bond funds involve extra risks and costs.

First, the costs.  When you own shares in a mutual fund you are liable to capital gains taxes whenever the fund sells its underlying assets at a profit.  Therefore, if other shareholders in the fund decide to cash out and redeem their shares, and the fund sells assets in order to meet their redemption requests, you could have to pay taxes for gains even as you hold on to your shares and even as the overall value of the fund may be decreasing.  The individual bondholder avoids this problem entirely.

Second, the risks.  The municipal bond market over the past year provides a vivid example of the unexpected risks that can lurk inside funds.

For the courtesy of lending your state and local governments money to build things, they won’t tax you on the interest you earn.  Uncle Sam too forgoes—for now—taxing savers’ income from state and local municipal bonds.  This prospect of tax-free income, along with the relatively certain return of principal from municipal borrowers, make municipal bonds a core feature of the average individual investor’s portfolio.  Fund companies cater to municipal bond investors by offering state-specific funds so that residents of Virginia, say, can get the tax benefits of owning municipal debt from their state.

For years municipal bond fund managers have exploited a tax loophole created by America’s imperial past: the interest on municipal and state debt from the U.S. protectorate of Puerto Rico is tax-free in all 50 states in addition to being exempt from federal taxes.  Puerto Rico’s relatively weak finances, compared to most American states, has meant that it must pay a premium to lenders.  The special tax-advantaged status of its bonds has incentivized Wall Street to juice the yield in state-specific municipal bond funds by quietly adding high-yielding Puerto Rican debt.  Thus holders of ostensibly staid and conservative Virginia or Pennsylvania municipal bond funds end up with sizeable, risky investments in Puerto Rico.

For example, according to Morningstar (as of October 17) the Oppenheimer Rochester Virginia Municipal Fund (ORVAX) had a whopping 31.07% of its assets invested in Puerto Rican bonds; the Nuveen Maryland Premium Inc Muni Fund (NMY) had 14.79%; the Nationwide Ziegler Wisconsin Tax Exempt Fund (NWJWX) had 20.42%.

The practice hummed along nicely with investors getting higher yields, fund managers higher fees, and Puerto Rico getting cheaper money, until the predictable excesses began.  Profligate government spending has weakened Puerto Rico’s finances and the quality of its debt has been downgraded to near-junk bond status.  In August Barron’s devoted a cover story to the island’s debt problem.  Furthermore, the expected tapering of the Federal Reserve’s quantitative easing (QE) program has provided an independent motive for bond fund investors to sell: a rise in interest rates as QE subsides would make their lower-yielding debt less valuable.

Accordingly, on December 15 Bloomberg reported that in the previous week investors had pulled $1.9 billion from municipal bond funds, adding to a total of $57.5 billion in withdraws this year so far.  Thus even fund managers whose faith in Puerto Rico’s debt remains unshaken have been forced to sell the bonds at steep losses in order to meet the redemption requests of their less sanguine shareholders.

The upshot is that municipal bonds are headed for their first annual loss since 2008, and many big municipal bond funds have lost 10-15%, even as the stock market and corporate bond market have continued to rally to all-time highs.  Most of the ordinary investors who bought such funds probably had no idea how risky their investments really were.  The whole mess makes a strong case for knowing what you own and owning it directly, and this is what fund investing can make difficult or impossible.