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Municipal bonds are demanding attention, again

| Sunday, Aug. 25, 2013, 9:00 p.m.

NEW YORK — Municipal bonds usually don't get much attention unless something's wrong. They're getting attention now.

Investors have been running away from bonds issued by state and local governments for several months, even though they offer tax-free income. The worries began when interest rates started to rise in the spring and heightened after Detroit became the biggest city in the country to file for bankruptcy.

The selloff is reminiscent of one that smacked municipal bonds in late 2010 and early 2011, when a prediction that a wave of defaults would hit the market. But now, like then, managers of municipal-bond mutual funds say the worries have initiated a buying opportunity.

Investors who bought in late 2010 did well: The average intermediate-term municipal bond fund returned 9 percent in 2011. Managers say such big gains aren't likely this year, but long-term municipal bonds can offer tax-free yields of 5 percent and have the potential to rise in price if interest rates don't take off, says John Miller, co-head of global fixed income for Nuveen Investments. Nuveen oversees $90 billion in municipal bonds.

Nearly every municipal bond mutual fund has lost money over the past three months. For a rebound in the municipal bond market to happen, it needs to snap out of the self-feeding selling cycle that has overtaken it.

Investors have been pulling money out of municipal-bond mutual funds since March, according to the Investment Company Institute. And the withdrawals have been accelerating: After yanking $1.8 billion out of municipal-bond funds in April, investors have pulled an average of $2.3 billion each week since the middle of July.

Detroit's bankruptcy filing in July raised further worries about the strength of the overall market. After seeing prices for their municipal bond funds fall, investors pulled money out in hopes of avoiding losses. But to come up with the cash to return to those investors, mutual fund managers had to sell some of their municipal bonds, which knocked prices down still further. That spurred more fund investors to pull their money.

“That's a very short-term mentality,” Miller says. “It has lasted longer than most municipal-market participants would have anticipated, but eventually that does stop.”

He says the market could return to a virtuous cycle where buying feeds more buying, and he lists several positives for municipal bonds: Budgets for state and local governments are generally in better shape, inflation is low and yields are looking more attractive.

The last one is key: Municipal bonds can offer higher yields than similar taxable bonds. The advantage in yield is even more pronounced after taking the tax effects into account. The top federal income-tax rate is 39.6 percent, up from 35 percent last year. Investors who own municipal bonds from their home states can avoid state income taxes. That means top income earners in California or New York could avoid more than 50 percent in total federal, state and other income taxes.

Some buyers have stepped in to take advantage, like pension funds and hedge funds, says Duane McAllister, portfolio manager of the $1.2 billion BMO Intermediate Tax-Free fund (MITFX). Although that hasn't been enough to halt the tide of money flowing out of municipal bond funds, managers see it as an encouraging sign.

A look at some of the biggest questions hanging over the industry, and what kinds of investors should be asking them:

— What about rising rates?

Speculation has been rising that the Federal Reserve will slow its bond-purchasing program later this year, which investors expect to result in higher interest rates.

Rising rates mean short-term municipal bond funds have lost an average of 1.3 percent over the last three months. Long-term municipal bond funds, which are more sensitive to changes in interest rates, have lost an average of 7.6 percent.

“Two years, three years down the road, we're expecting rates to be higher,” says Jim Colby, senior municipal strategist and portfolio manager at Van Eck's Market Vectors exchange-traded funds. “But how do we get there and when do we get there? That is still very much uncertain.”

— What about Detroit?

Detroit's bankruptcy filing frightened many investors, but municipal bond defaults are rare. From 1970 through 2012, the credit-rating agency Moody's counted 73 municipal defaults, which translates into an average annual default rate of 0.01 percent. For corporate bonds, the average annual default rate is 1.68 percent. Defaults have picked up a bit since the recession, but only enough to nudge the average annual default rate for municipals up to 0.03 percent over the last five years.

To be sure, governments are still facing pressure from their pension obligations. But their tax revenues are also rising: States collected 8.6 percent more in tax revenue during the first quarter of 2013 than they did a year earlier. It's the 13th consecutive quarter of growth, according to the most recent data from the Rockefeller Institute of Government, which tracks state and local finances.

— Who should own municipal bonds?

Income payments made by municipal bonds are free from taxes, so taxpayers in the highest brackets get the biggest after-tax boost.

BMO's McAllister says municipal bonds make sense for investors in the 28 percent income-tax bracket and above. For a single filer, that means anyone with taxable income of more than $87,850. For a married couple filing jointly, that means making more than $146,400.

— Who shouldn't own municipal bonds?

Investors looking to put money to work in their 401(k) or other tax-deferred account. That would be a missed opportunity to benefit from putting taxable investments like stocks or corporate bonds in those accounts.

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