Marc Ruiz: May be time to lock in municipal-bond profits

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Updated: March 6, 2012 8:22AM

Ray from Highland recently sent me an email asking about for my thoughts on municipal bonds, commonly known as muni’s. I always appreciate hearing from readers so I’d like to discuss what has been going on with this interesting corner of the bond market.

Municipal bonds are issued by state and local governments for a variety of purposes. These government entities use the funds raised from selling bonds to fill budget gaps, finance local projects and subsidize various public needs.

Muni’s have traditionally enjoyed a tax-privileged status as the great majority of these bonds pay interest that is free from federal income taxes and in some cases, when purchased by residents of the same state, free from state income taxes as well.

These tax-free interest features allow the state and local government to borrow money from bond holders at lower interest rates that, when adjusted for taxes, can still be attractive to some investors.

Muni’s also typically have a high claim on municipal tax and service revenues and because of this these bonds have been traditionally considered as mostly conservative investments.

Late in 2010, high-profile Wall Street investment analyst Meredith Whitney appeared on the CBS program “60 Minutes” and put out a dire warning that the municipal bond market was the “next shoe to drop” in the financial crisis. She predicted hundreds of billions of dollars in defaults in these bonds over the next year and a half. The story was terrifying to the conservative investors who typically invest in these bonds and as a result muni prices in general got slammed.

When the dust settled from the selloff, many investors took an earnest second look at the safety inherent in municipal bonds and made the correct conclusion that a great majority of these bonds were safe after all. These second looks led to a renewed interest in muni’s and resulted in a nice rally in muni prices over the past year or so.

Which leads us to Ray’s question and my current opinion.  

First, I like municipal bonds and have always been attracted to their safety and tax features. Many of these bonds are backed by revenues from “mission critical” infrastructure like water plants and airports, which must continue to function even if the economy slips.  

That being said, many muni’s are trading at high prices and yields in this market tend to be lackluster at this time. Investors may be tempted to buy bonds with longer term maturities in an effort to get higher yields. While this may work out OK for a while, investors who choose to do this need to prepare themselves for the time when interest rates eventually rise, which will cause their long-maturity bonds to lose a fair amount of value.

And second, if you bought a municipal bond mutual fund with the intention of receiving a 2.5 percent to 4 percent tax-free yield and your fund has provided a double-digit return over the past year (many did), I do think it’s worth taking a look at locking in some of those profits.