Two Rules for Owning Muni Bond Funds

In the wake of Detroit’s bankruptcy, many municipal bond funds have sold off.  And that leaves income investors wondering whether now is the time to buy the dip or sell their bonds.
Several Income & Prosperity readers vehemently disagreed with my thoughts on municipal bonds in last week’s issue (see The Real Reason to Sell Municipal Bonds).
Specifically, it seems that my conclusion turned off some readers:

You better be prepared for lost principal value when interest rates start rising. Even AAA bond ratings and bond insurance won’t help when the Fed starts raising rates.

The end of QE3 – also known as Fed tapering – is just the start.  Looking forward a couple years, interest rates will actually start ticking up.  And when they do, you won’t want to be holding Treasuries, municipal, or even corporate bonds with lengthy durations.

In response, several of my readers wrote in.  Here is what one reader said:

You talk like buyers of bonds are looking for some sort of trading like stocks. I bought muni bonds for the tax-free return. In my tax bracket my 5.5% muni bonds are the same as 8-9% percent taxable interest. If I hold them until [maturity] I lose no principle. Your scare tactics don’t work on anyone who knows why they buy [municipal bonds].

Since I received similar emails from several readers, I want to set the record straight. I have no vested interest in scaring my readers or creating panic.
My goal was simply to point out that rising interest rates result in declining principal values.  When interest rates start rising – which is inevitable in the coming years – the values of even the highest rated muni bond funds will fall.
What I failed to say in last week’s article was the bonds held until maturity will pay out one-hundred cents on the dollar, assuming that the municipality hasn’t gone bankrupt.
If you buy individual, highly rated muni bond funds, you can achieve healthy returns.  However, you must follow two important rules.
First, you must own individual, rather than bond funds. By owning individual bonds, you can choose to hold it until its maturity date.
Bond mutual funds and ETFs have a rolling inventory of bonds with varied durations. This means that a shareholder can’t simply own the fund until its maturity date. So whenever you sell your shares in that fund, you’ll be cashed out based on the current market value of the holdings.
Second, you must be prepared to hold those bonds until their maturity date.  The reason is that if interest rates rise, principal values of those bonds decline. And you don’t want to be forced to sell these “safe” investments at a loss.
By holding the bond until maturity, you’ll be paid back the principal by the borrower (assuming there are liquid and can make good on their debt obligation).
For investors who are comfortable locking up their cash for five, ten, or twenty years muni bonds can be a good source of income. But if it’s possible that you’ll need to sell before the maturity date, there is the risk that you will not receive 100% of your principal.
One of my readers is doing exactly this.  Here’s how he describes his municipal bond investment strategy:

We’re interested in safety and income. The sweet spot for us is being able to earn an average of 4.5% tax free from investment grade, quality, munis. While yields certainly will vary, we don’t shy away from long-term bonds because we hold to maturity (unless called).

Fluctuation in valuation of principal doesn’t matter to us. As bonds have been called, we selectively reinvest and also build cash reserves for when rates will hopefully rise. The approach we use is our own version of laddering. We purchase individual bonds, read the official statements, research the issuer and factor in the economic trend and overall market place.

This is exactly the right approach to take with muni bonds: buy high quality, individual bonds and hold them until they mature.
Last week I also told you that muni bonds are more attractive than U.S. Treasuries for a couple reasons. AAA-rated muni bonds pay 1% more interest than T-bills. Plus they offer some compelling tax advantages, especially for high-income earners.
Considering that no AAA-rated muni bond has ever defaulted, these investments are a far better investment than a savings account or Treasuries.

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