- Money has piled into municipal bonds as investors aim to lower risk and reduce taxes.
- Some investors may worry about price declines as the Federal Reserve plans for intererst rate increases.
- But muni bonds may see higher coupon rates, and a well-built portfolio may still achieve long-term goals, financial experts say.
Money has piled into municipal bonds, known as muni bonds or "munis," as investors aim to lower risk and reduce taxes. But some may worry about price drops amid rising interest rates.
Investors funneled a record-breaking $96.8 billion of net money into U.S. muni mutual and exchange-traded funds in 2021, according to Refinitiv Lipper data.
"2021 was pretty significant," said Tom Kozlik, head of municipal research and analytics at Hilltop Securities. "We saw more fiscal policy focused on public finance than we ever have in a single year."
Some investors, however, may now be bracing for the Federal Reserve's planned interest rate hikes, which may cause price declines.
But advisors are still optimistic about muni bonds for certain clients, particularly for long-term portfolios.
"Higher interest rates will bode well for the average municipal bond investor," said certified financial planner Jay Spector, partner at Barton Spector Wealth Strategies in Scottsdale, Arizona. "They're potentially going to see higher coupon rates."
And if you're eager to buy muni bonds with higher yields, you may have the chance to buy assets at a lower price, he said.
"I absolutely think that munis have a place in someone's taxable portfolio," said Spector.
The tax benefits of muni bonds continue to shine, as the assets generally enjoy no federal tax on interest, and avoid state and local levies on yields, depending on where investors live.
While many of President Joe Biden's proposed tax hikes have faltered in Congress, levies will increase after 2025 as provisions sunset from Republicans' 2017 tax overhaul.
"Munis gives you that counterbalance to potential inflationary hikes in tax rates," said Ian Weinberg, CFP and CEO of Family Wealth and Pension Management in Woodbury, New York.
Although muni bonds may offer lower interest than a corporate bond with similar credit risk, the pre-tax yields may be deceiving.
For example, let's say you're in the 35% tax bracket, comparing an 8% corporate bond to a 5.25% muni bond. While 8% may seem like a higher return, the corporate bond pays 5.2% after taxes.
How to craft a muni bond strategy
Crafting a muni bond portfolio isn't easy, even for advisors, who may rely on institutional muni bond managers to adjust holdings based on interest rates, credit quality changes and more.
"You could walk into a disaster if you do it yourself," Weinberg said, explaining the high level of monitoring needed for muni bond investing.
For example, muni bond issuers may "call" the asset, paying it off before maturity, when interest rates drop. The move allows issuers to replace it with another lower-paying bond, blocking investors from the higher rate.
Muni bond managers may add call protection to stop issuers from calling the assets for a set period, making adjustments to the portfolio over time.
While credit concerns in the public finance market have "really decreased," according to Kozlik, it's also critical to research each muni bond's credit quality, which may change over time due to local economic factors.
"It's not as easy as just throwing a dart against the board and picking a stock," Spector added.