Market rout has muni bonds looking attractive. How to add them to your portfolio

Published Sun, Sep 25 20229:22 AM EDT

The recent market turbulence has investors searching for income. For some, municipal bonds may be the answer. The muni market has taken a beating this year, with net weekly inflows into muni mutual and exchange-traded funds negative for most of 2022, according to Refinitiv Lipper data. Yet their yields and tax benefits can make them an attractive investment. The debt securities are issued by government entities, such as a city or state, and raise money for public projects, such as building roads or schools. They are generally free of federal taxes on interest and may avoid state and local levies, depending on where you live. "The states are in really good shape to pay off their bonds, so it makes the safety of the munis even better than they ever have been," said certified financial planner David Sheaff Gilreath, partner and chief investment officer at Indianapolis-based Sheaff Brock Investment Advisors. Jason Ware, head of municipal bond trading at InspereX, has seen a "tremendous uptick" in buying and selling the fixed-income asset over the last two to three weeks. "Uncertainty around how high interest rates will go has driven redemptions in muni bond funds," he explained. "This was coupled with a heavier new issue calendar up until the imminent Fed decision, creating supply pressure [and] driving nominal yields and credit spreads sharply higher, making them much more attractive." The tax benefits make munis particularly attractive to high-earners in high income tax states. Those tax savings are even more critical in a time when stock returns are scarce. The market took a nosedive Friday, with the Dow setting a new low for the year . "We always like to buy municipal bonds," said CFP Ian Weinberg, CEO of Family Wealth and Pension Management in Woodbury, New York. "When rates were very low, it wasn't as exciting, but today it is a pretty good deal. Whenever we have a chance to add to muni bonds now, we do so." A good signal to buy is when municipal yields on a particular duration are at least 85% of corresponding Treasury yields , he said. That's because with a Treasury, you are paying tax on your interest earnings. Therefore, even if a highly rated muni bond of the same duration has a yield that is lower, you still may be earning more since they generally aren't being taxed. For instance, a 12-year tax-exempt California bond paying a 4% semi-annual coupon, with an essential service or general obligation type backing, can yield you a 3.7% return, said InspereX's Ware. For a high net worth individual in the highest tax bracket, that is equivalent to a 6.25% taxable yield. Meanwhile, the 10-year Treasury is currently yielding just under 3.7%. How to buy munis For investors looking to get into the muni market, there are a few ways to do so. To buy individual issues, you can use a broker-dealer, hire an investment manager, or trade directly through a self-managed online account. For instance, you can go to Fidelity Investments' website and access more than 50,000 municipal bonds as new issues or through dealers on the secondary market. However, if you choose to make your own direct purchases, be sure to do your homework, said Richard Carter, vice president of fixed income at Fidelity. "For investors considering a strategy that incorporates municipal bonds, they should first ensure they understand these offerings and how they fit into their overall financial plan," Carter said. Fidelity also offers muni bond mutual funds and exchange-traded funds, as well as municipal separately managed accounts. Both Ware and Weinberg don't advise going it alone when it comes to buying individual municipal bonds. There are so many different issuers and choices of bonds, and there are credit ratings to consider. There are also price discrepancies, with smaller investors usually at a disadvantage. "You don't want to be the bondholder who got greedy for extra yield and bought the wrong bond," Weinberg said. They suggest working with a professional who can manage the account. You can also get muni bond exposure through a mutual fund or ETF. Those who want a wide range of bond exposure, such as maturities, sectors and credit, and have limited funds could look at investing in a mutual fund or ETF, according to the Municipal Securities Rulemaking Board. Individual bonds vs. funds When buying individual municipal bonds, work with a financial advisor or bond manager and focus on good credit quality securities, like general obligation, voter approved, and essential services, suggests Ware, who is based in San Francisco. The fees will vary, with managers typically charging a percentage of the assets under management. The advantage of owning bonds over investing in a fund is that if you hold the bond to maturity, you get your principal back, he explained. You can also control your credit risk and build your own portfolio. Having a separately managed account instead of a fund also allows you to ladder munis, investing in multiple bonds with different maturities. That is a good strategy, particularly when interest rates are rising, Ware said. As rates go up, you have principal coming due that you can reinvest at the higher interest rates. There is also good tax management in the separately managed accounts, Family Wealth and Pension Management's Weinberg said. "If some bonds are in loss positions, you can have the manager use those losses for tax loss harvesting against future gains in other investments," he said. Weinberg uses an institutional municipal bond manager to handle his clients' tax-free bond portfolios. However, he believes this route is best for those investing at least a quarter of a million dollars, so that they get the right diversification. For those who may have less money to invest, a mutual fund or ETF may be a better option, he said. "There is nothing wrong with that. It just doesn't give you as much of a sense of certainty that you get from your muni bond investment," Weinberg said. Here are five Morningstar five-star rated muni bond funds. For Sheaff Gilreath, funds are exactly where he wants to be. Specifically, he said he is investing in closed-end bond funds because that's where you can buy the cheapest bonds. "Many closed-end bond funds are trading at prices that are below their net asset value," he said. He likes Putnam Managed Muni Income and Rivernorth Flexible Muni Income funds. Putnam has a 6.37% distribution yield and is currently trading at a 4.44% discount to its net asset value. Rivernorth is trading at an 11.43% discount and has an 8.26% distribution yield. Whether you strike out on your own or use a fund, financial advisor or separately managed account, make sure you do your research and understand any and all fees involved.