In this Ask The Expert With Larry Swedroe article, Randy wants to know if now is a good time to invest in municipal bonds. Here’s the question from Randy:
As you know, municipal bond funds have been hit hard by the current financial crisis and have put in new 52-week lows recently. I noticed however, that their prices are now heading back again. Their yields are very attractive. Do you believe there is renewed confidence that the government will help municipalities with capital, causing stability in the muni market, or do you feel that these are still too risky for investments at this time? Also, are insured tax-exempt funds safer, and if you feel muni bond funds are safe to go back into, what term (i.e., intermediate, long term) would you recommend?
First, while all municipal bonds have been hit by the flight to quality and liquidity, the safest bonds, the only kind I recommend, with AAA/AA underlying ratings, have held up reasonably well. And in last few days they have actually rallied quite a bit as the liquidity crisis starts to ease. And while there will likely be problems with some municipal bonds, it is highly unlikely that the highest grade bonds will default. Remember that they have taxing power that corporations do not. All of my personal fixed income assets are basically either in TIPS (in my tax advantaged accounts) or in AAA/AA munis (in my taxable accounts).
Second, while it may not be practical for most individuals, I prefer to buy individual bonds so that I control the credit risk. But for most, funds will be most appropriate to get the needed diversification and access to institutional pricing.
Third, right now munis represent, from a historical perspective, a tremendous buying opportunity (but again I would stick only to the highest investment grade bonds) as they typically trade at between 80-95% of Treasuries but now at well above 100% (in some cases as high as 125%). And if Obama wins as seems likely they should get even more attractive due to higher tax rates on the wealthy.
Fourth, the yield curve is fairly steep and historically speaking you have been rewarded for taking risk in such environments. A good rule of thumb I think is that you generally stick with intermediate bonds, though if getting about 15bp more per year you might want to consider going longer — keeping in mind you do take on more inflation risk (but at least you are getting compensated for it). If you do go longer, be sure that you can accept the incremental inflation risk.
My book, The Only Guide to a Winning Bond Strategy You’ll Ever Need, goes into a good amount of detail on most fixed income investments and does include a full chapter on municipal bonds and what I believe is the winning strategy.
I hope that is helpful