Compared to the ups and downs of the stock market, many investors think of bond investing as boring. But a rare opportunity in bonds has the fixed-income market turned upside down, and the best way to take advantage may be to shift bond allocations toward municipal bonds.
Muni bond basics
Municipal bonds are issued by state and local governments to finance various programs. Their primary benefit is that the federal government doesn't make you pay tax on interest from munis. In addition, you also don't have to pay state income tax on that interest, as long as you buy munis that are issued in the same state.
Because of these tax benefits, muni bond yields usually have substantially lower yields than you'll find from similar Treasuries and other taxable bonds. But while Treasury yields have been in a downtrend for months and have dropped precipitously in recent weeks, muni yields have actually been rising over the past six months. The resulting convergence of rates -- 30-year AAA-rated municipal bonds currently pay just 0.1% less than 30-year Treasuries -- has made munis much more attractive on an after-tax basis.
For instance, at current rates, you could get a 30-year Treasury paying 4.72%, or a 30-year muni paying 4.61%. Even if you pay just 15% in taxes, the after-tax yield on the Treasury would be just more than 4%. Put another way, the Treasury would have to pay 5.42% in order to give you the same amount of money after taxes that the muni bond gives you.
Bonds have always been more difficult to buy than stocks. With discount brokers, buying stocks is easy -- quotes are readily available and easy to understand. On the other hand, municipal bond sales have traditionally been dominated by large brokerage firms, including Citigroup (NYSE: C ) , Merrill Lynch (NYSE: MER ) , and UBS (NYSE: UBS ) .
Even though some discounters have come into the bond arena, buying individual bonds is still more challenging for the average investor. It requires a commitment to learning about how various brokers price bonds. You also have to be careful about hidden costs, as commissions are often included within the price of the bond.
Lately, whenever a particular market gets hot, exchange-traded funds come into that sector. In the muni bond arena, Barclays (NYSE: BCS ) has just opened an ETF that holds municipal bonds. The iShares S&P National Municipal Bond Fund (AMEX: MUB ) offers investors an easy way to get a diversified portfolio of municipal bonds. Its low expense ratio of 0.25% compares favorably with traditional muni bond mutual funds.
With all the uncertainty in the financial markets, many markets that usually trade in tandem have decoupled from one another. By being alert, you can take advantage of these imbalances. Adding municipal bonds to your fixed-income portfolio may let you increase your income while keeping risk levels relatively low.